What Is Happening to Term Premia on Gilts?
Jun 15, 2006
David Miles (London) and Vladimir Pillonca (London)
It is useful to think of the yield on a bond as reflecting the average expected short-term interest rate over the life of that bond and a residual factor that is often called a ‘term premium’. This term premium is a catch-all for a range of factors that drive a wedge between the yield on a longer-dated debt instrument and the expected return from investing in a series of short-dated instruments. The kind of factors that can affect term premia include: assessments of the risk in buying long-dated instruments in an environment of uncertainty about inflation and monetary policy; the need to hedge liabilities that might be bond-like and have long duration; and the relative supplies of long-dated bonds and short-dated instruments. All these factors, as well as being potentially powerful drivers of yields, are likely to vary over time.
Figuring out where term premia have been in the past, and how they might change in the future, is tricky. But it can throw useful light on how bond prices might evolve. It is likely that term premia are both significant and vary over time; so to ignore them — and simply assume that the only factor driving yields on longer-dated bonds is expectations of how monetary policy will evolve and how the central bank will change short rates — would be misleading. In a new report (What Is Happening to the Risk Premia on Bonds?, Vladimir Pillonca and David Miles, June 14, 2006), we try to answer four questions about yields on UK government bonds (gilts): * Has there been a secular decline of term premia on gilts that has reduced long-term yields? * Is this likely to prove permanent, or is it just a temporary phenomenon? * How are yields on UK government bonds likely to evolve in the near future and beyond, if term premia evolve as projected by our models? * What would happen to UK yields should term premia unexpectedly revert back to their historical averages? To assess the issues, we first estimate how expectations of future levels of short-term interest rates might have been made in the past. We do this by using a simple statistical model of what drives short rates. We then use that to form an historical record of how expectations of short rates would evolve, based on the information that people would have had in the past. The deviation between those expectations and actual past gilt yields is our estimate of term premia. We then use the historical pattern of these derived term premia to see what factors may have driven them. We do this in a simple way, allowing term premia to depend on their own past history and on changes in short rates and past yields. We are then able to project forward how those factors might evolve and so come up with an estimate of where term premia on bonds of different maturities might be going. Finally, we use that information to come up with rough estimates of where yields might go. We reach several conclusions First, term premia on gilts of all maturities have fallen to levels well beneath their long-term averages. This has been a factor in recent years in taking bond yields to what are — by historical standards — low levels. The term premia on 20-year gilts is estimated to have fallen from about 80bp in 2002 to close to about zero today. Second, that recent low term premia — relative to historical averages — are likely to persist so that they will not revert to their long-run averages. Our projection of where the term premium on long bonds will go is much lower than a simple forecast based on the idea that the term premium reverts to the long-run average. But for longer-dated bonds, there is nonetheless a tendency for term premia to move a little higher over the next few years. Finally, we generate some implied forecasts for yield levels by adding the estimated term premia to forecasts of where average expected future short rates (set by the Bank of England) will go. We expect short rates to move up slightly in the UK and for term premia to also edge higher. So the combination of these factors means that the model we have developed suggest that yields will move up somewhat — especially at the longer end.
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A Fistful of Dollars
Jun 15, 2006
Serhan Cevik (London)
Liquidity-driven speculative capital is leaving Turkey’s financial markets. Regardless of whether there is an economic justification for the sudden eruption of financial volatility, the reality is painful enough to have all of us paying the utmost attention. In our view, financial deleveraging — accelerated by central banks’ response to overwhelmingly commodity-based inflationary pressures and tightening liquidity conditions — has hit a critical threshold and triggered a wave of risk reduction across all asset classes. Given the extent of liquidity-driven speculative positions around the world, a herd-like rush to outmanoeuvre others should surprise no one in the investment community. In Turkey’s case, for example, in the 16 months from January 2005, capital inflows that could be categorised as ‘hot money’ amounted to $18.1 billion and, coupled with other factors, pushed the lira’s valuation beyond the comfort zone. Unfortunately, with the burst of global volatility in the last month-and-a-half, these highly fluid funds invested mainly in stocks and government bonds have started leaving Turkish markets, putting tremendous pressure on the lira. The ‘liquidity shock’ partly reflects an increase in the degree of home bias among foreign investors. Turkey has become one of the worst-performing markets, although economic fundamentals are strong enough to withstand the global liquidity shock. We think that technical conditions (mainly stemming from the international position of banks and non-financial firms) and the burden of energy imports have played a role in the country’s disproportionate response to global fluctuations. Even so, the sell-off cannot be explained away by domestic factors, and is primarily driven by a rise in the degree of home bias among foreign investors. Liquidity-driven capital inflows that once led to the lira’s over-appreciation have suddenly become outflows and weakened the exchange rate beyond its fair value. But was the lira’s revaluation just an illusion created by global liquidity? Even though valuations may indeed disconnect from fundamentals, the lira’s appreciation in the post-2001 period was not just about capital inflows, in our view. Economic normalisation and structural changes have been the primary determinant of portfolio decisions and therefore the exchange rate’s trajectory (see Stabilisation and Asset Prices, April 16, 2004). The Bureaux de Change that once sprung up all around the country have gone out of business. In a country like Turkey that suffered from political instability and economic volatility for over three decades, expectations are crucial and can have extensive influence over economic variables. For example, recurrent bursts of uncertainty resulted in a loss of confidence among residents and persuaded them to hoard foreign currency-denominated assets and to use foreign currencies as a medium of exchange. Not surprisingly, Bureaux de Change sprung up all around the country, and the share of foreign currency-denominated instruments in total financial holdings continuously increased — reaching 43.2% after the crisis in 2001. Consequently, the lira remained excessively undervalued for a long time. However, with the normalization of political and economic landscapes, residents have dramatically altered their portfolio preferences in favour of lira-denominated instruments. The share of foreign currency-denominated assets declined from its post-crisis peak to 29.3% in 2004 and then to 25.6% at the end of last year. In our view, this process of financial de-dollarization — reflecting fundamental improvements in the economy — has been the overwhelming factor influencing the lira’s revaluation. Residents have not lost confidence in Turkey’s macroeconomic outlook. Despite a significant outflow of foreign capital and the resulting weakness of the exchange rate in recent weeks, Turkish residents have not changed their minds about the country’s economic and financial outlook. According to the latest figures (corrected for exchange rate movements), the share of foreign currency-denominated assets declined to 24.8% of residents’ financial portfolios last month. Indeed, if we adjust for the Vodafone payment of $3.8 billion, it is probably now around 23.5%, and shows no sign of a loss of confidence among residents at this stage. In other words, the share of lira-denominated assets has increased, for the first time in decades, to over 75% of domestic savings, making Turkey one of the unique cases of successful de-dollarization. Looking forward, the slope of reverse currency and asset substitution may not be as steep as it was in the past, but should remain supportive as long as there are no more disconcerting policy mistakes. In turn, we believe that de-dollarization of residents’ financial holdings will continue to lower macroeconomic volatility and improve the central bank’s control over monetary developments.
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BoJ's Moment of Truth
Jun 15, 2006
Takehiro Sato (Tokyo)
The BoJ is likely to become a lame duck Fallout from Governor Fukui’s Diet remarks on June 13 regarding his ¥10 million contribution to the Murakami fund could take on surprising proportions going forward. The BoJ initially said that this did not represent a flouting of its internal rules. However, one question that we expect to receive a lot of attention is whether Governor Fukui’s request of several months ago for his contribution to be cancelled (according to his own remarks) comes under the heading of a constitutional issue relating to insider trading. Alternatively, the question is whether the rescission application was made in compliance with BoJ internal rules. If it were found, for example, that the required procedures were not adhered to, the governor’s position could become decidedly shaky. What is more, whether or not Mr. Fukui himself emerges unscathed, there is potential for the issue to develop into one of political capital. An alternative possibility would be that a political ‘deal’ might be entered into between Mr. Fukui as head of the central bank and those politicians who oppose an early hike in interest rates at a time when the stock market is falling so sharply. In either case, we think that the governor would find his credibility undermined, and his ability to manoeuvre in terms of policy damaged. In the worst case, it could lead to a second fall from grace, with removal from the BoJ headship, for Mr. Fukui. And if matters went that far, it would likely be a considerable time before the central bank is able to restore its tarnished credibility. Prospects of a July 14 rate hike suffer a setback We feel bound to conclude that, coming on top of the recent steep slide in the stock market, this scandal severely reduces the likelihood of ZIRP being lifted in July. Up to now we saw a 60% subjective probability of a July rate hike, but we have reconsidered and now see the probability as 60% through August-September, and 30% in October-December, with a 10% probability of no rate hike within the year. Our main scenario is now an August 11 rate hike. This is the sixth anniversary of ZIRP being lifted and a bad omen for the BoJ. However it cannot be helped, given the seriousness of the scandal. I do not think I am the only one who thinks it may be fate. There are a number of reasons why we believe that the prospect of a rate increase has slipped back by only one month, one being that this may be a relatively favorable time for the stock market to have come through a healing process and pick up as the market expects companies to revise up profit forecasts ahead of the earnings season. Another is that up to August is an important ‘window of opportunity’ for the BoJ, given our US monetary policy scenario in which we are looking for the August 8 FOMC to be the final phase of the tightening session. Another is our expectation that the impact of the scandal should diminish somewhat once through the summer, as market and public interest turns to such matters as the line-up of the new Cabinet and the headwind against the BoJ is expected to ease. However, if this scandal escalates to the point of prematurely ending the governor’s career, quite naturally it would be tough to do a rate hike even in August. At all events, while the prospect of higher rates may have been put back, as long as monetary policy remains a tool for making political capital we do not see how this can be good for the asset markets. Modifying our interest rate outlook As mentioned above, we have reviewed our interest rate table in light of the current steep slide in the stock market and this latest scandal to emerge in connection with the BoJ, and our main scenario is now that ZIRP is likely to be lifted in August. We now expect the rate hike schedule to feature one hike during 2006 followed at about a six-month interval by just one more in 2007, adding up to +50bp in total. As before, our reasons for anticipating just two rounds of rate increases are that, firstly, we assume that productivity will continue to improve at the current pace and we therefore have a somewhat more cautious view on the outlook for prices than either the market consensus or the BoJ’s forecasts. Secondly, we expect a heavier focus on the policy mix involving fiscal policy after the new Cabinet gets going in late September, or perhaps after the Upper House elections in summer 2007. Thirdly, we allow for the prospect that US monetary policy will start easing from 2H07. Along with the change in our outlook for monetary policy, we have also adjusted our view on long-term interest rates. We do not expect the trajectory of the 10-year JGB yield to go far above 2% ,and we expect the yield to peak out in mid-F2006. As a result of this, while not to the same degree as in the US, we foresee an increasing flattening bias for Japan as well.
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