1. Prepared to Tighten:
Rates and Curve Dynamics During Rate Tightening
Cycles
Monica M. Kelly
Jetskelly1@yahoo.com
November, 2009
2. The Rates and Curve Dynamics During Rate Tightening Cycles
1. The Four Recent Episodes of Rate Tightening Cycles
2. The Short Rates Dynamics
a. Policy Rate Normalization: Taylor Rule
b. Short Rate Normalization
3. The Long Rates Dynamics
a. Diminishing Inflation Expectation
b. Shift in Portfolio Preference
4. The Curve Dynamics of Rate Tightening Cycles
5. Summary
3. As recent as this month, the Federal Open Market Committee reiterated its pledge to keep the benchmark lending rate, the Federal
Funds Rate, at near zero “for an extended period” to boost a weak economic recovery with high unemployment rate. However, given
recent signs of positive momentum in manufacturing, retail sales, trades, and housing activities, the Fed Chairman, Ben Bernanke, has
begun to introduce expectation of rate tightening. “As economic recovery takes hold, we will need to tighten monetary policy to
prevent the emergence of an inflation problem down the road,” Bernanke said at a Board of Governors conference on monetary
economics in Washington on October 8. “When the economic outlook has improved sufficiently, we will be prepared to tighten.” This
note looks at rates and curve dynamics of an eventual imposition of a policy rate tightening cycle. To that end, we would first look at
facts and inferences drawn from four recent major episodes of rate tightening cycles.
1. Four Recent Major Episodes of Rate Tightening Cycles:
14 3
Episode 2: Feb 1994 – Feb 1995 Episode 4: Jun 2004 – Jun 2006
Episode 1: Feb 1988 – Feb 1989 Episode 3: Jun 1999 – May 2000
12 2.5
2
10
1.5
8
1
6
0.5
4
0
2 -0.5
0 -1
1/ 9/ 1983
7/ 1/ 1983
1/ 1/ 1 84
7/ 1/ 1984
1/ 1/ 1 92
7/ 9/ 1 92
1/ 0/ 1 93
7/ 1/ 1993
1/ 1/ 2 01
7/ 1/ 2 01
1/ 1/ 2 02
7/ 1/ 2 02
1/ 1/ 2003
1/ 1/ 1985
7/ 1/ 1985
1/ 1/ 1986
7/ 0/ 1 86
1/ / 1 9 7
7/ 9/ 1987
1/ 9/ 1988
7/ 1/ 1 88
1/ 1/ 1989
7/ 1/ 1989
1/ 1/ 1990
7/ 1/ 1990
1/ 1/ 1 91
7/ / 1 1
1/ 9/ 1994
7/ 1/ 1994
1/ 1/ 1995
7/ 1/ 1 95
1/ / 19 6
7/ 1/ 1996
1/ 1/ 1997
7/ 0/ 1997
1/ 1/ 1 98
7/ 9/ 1998
1/ 0/ 1999
7/ 1/ 2099
1/ 1/ 2 00
7/ / 2 0
7/ 0/ 2003
1/ 0/ 2004
7/ 1/ 2 04
1/ / 20 5
7/ 1/ 2005
1/ 1/ 2006
7/ 1/ 2006
1/ 1/ 2 07
7/ 1/ 2007
1/ 1/ 2008
7/ 0/ 2008
/2 9
9
31 98
31 99
31 99
31 00
29 00
31 0
00
3 9
2 9
3 9
3 9
3 0
3 0
3 0
3 0
3 0
7 / 1/ 19
3 9
3 9
2 9
3 0
3
2
3
3
3
3
3
3
3
3
3
3
2
3
3
3
3
3
3
3
3
3
3
3
2
2
3
3
3
3
3
3
3
3
3
1/
2s10s Slope Fed Funds Rate
4. Rate Tightening Episodes:
1: Feb 1988- Feb 1989
a. The Fed Funds rate hiked 3.25% from 6.5% to 9.75%
b. The 2s jumped 2.57% from 7.10% to 9.67%
c. The 10s jumped 1.13% from 8.15% to 9.28%
2. Feb 1994 – Feb 1995
a. The Fed Funds rate hiked 3% from 3% to 6%
b. The 2s jumped 2.12% from 4.66% to 6.78%
c. The 10s jumped 1.07% from 6.13 % to 7.20%
3. June 1999 – May 2000
a. The Fed Funds rate hiked 1.75% from 4.75% to 6.5%
b. The 2s jumped 0.85% from 5.51% to 6.36%
c. The 10s jumped 0.25% from 5.78% to 6.03%
4. June 2004 – June 2006
a. The Fed Funds rate hiked 4.25% from 1% to 5.25%
b. The 2s jumped 2.27% from 2.68% to 4.95%
c. The 10s jumped 0.40% from 4.58% to 4.98%
In these four major episodes of rate tightening cycles, we observe short rates such as the 2s are substantially more sensitive to policy
rate changes than the long rates such as the 10s. The eventual rise in the 2-year yields were larger in magnitude than the rise in the 10-
year yields; on average, the 2-year yield normalized 3/4 of the magnitude of the rate tightening during the rate hike cycles while the
10s normalized only 1/3 of the rate hikes, causing the 2s 10s slope to flatten in an upward directionality. In fact, by the end of the
four tightening cycles, the FFs10s slope had completely inverted in three of the four episodes.
Treasury Rates and Curves In Recent Rate Hike Episodes
3/1988-2/1989 2/1994-2/1995 6/1999 - 5/2000 6/2004-6/2006
Start End Rate/Slope Chg Start End Rate/Slope Chg Start End Rate/Slope Chg Start End Rate/Slope Chg
FF 6.75 9.75 3.00 3.25 6 2.75 5 6.5 1.5 1.25 5.25 4
2s 7.10 9.67 2.57 4.66 6.78 2.12 5.51 6.36 0.85 2.68 4.95 2.27
10s 8.15 9.28 1.13 6.13 7.20 1.07 5.78 6.03 0.25 4.58 4.98 0.40
ff-2s slope 0.35 -0.08 1.41 0.78 0.51 -0.14 1.43 -0.30
2s10s Slope (%) 1.16 -0.39 1.47 0.42 0.27 -0.33 1.90 0.03
5. Now that we have observed the changing dynamic of the treasury curve is predominantly a bearish flattening dynamic which begins at
the end of an on-hold policy cycle and onward into a policy tightening cycle, and that the changing curve dynamic is primarily led by
the front end more so than the long end of the curve. One would have to ask, what drives the different normalization paths between the
short and long rates during policy rate tightening cycles?
2. The Short Rate Dynamics
Empirical observation we established earlier that short term interest rates such as the 2s are substantially more sensitive to policy rate
changes than the longer end. A few inferences can be drawn: 1) US policy rate, the Fed Funds Target Rate, and the 2y UST yield tend
to move in tandem as demonstrated in the graph below. This co-movement pattern implies a strong rate directionality between the Fed
Funds Rate and the 2y UST yield. 2) Despite their strong rate directionality, the normalization processes of the US policy rate and the
2y UST yield run at different speeds once the policy rate tightening cycle begins. As aforementioned, on average, the 2-year yield did
not completely normalize the rate hikes, it only normalized 3/4 of the rate tightening during previous policy rate hike cycles, some of
the short rate normalization had already happened while the Fed remained on-hold. 3) Policy rate normalization expectation drives the
short rate dynamics once the rate tightening cycle begins. To understand the short rate dynamics during rate hike cycles, one has to
understand policy rate normalization drivers.
Policy Rate and Short Term Rate
25
20
15
10
5
0
10/30/1981
11/30/1982
12/30/1983
10/31/1994
11/30/1995
12/31/1996
10/31/2007
11/28/2008
8/31/1979
9/30/1980
2/28/1986
4/29/1988
5/31/1989
6/29/1990
7/31/1991
8/31/1992
9/30/1993
2/26/1999
3/31/2000
4/30/2001
5/31/2002
6/30/2003
8/31/2005
1/31/1985
3/31/1987
1/30/1998
7/30/2004
9/29/2006
Fed Funds 2Y UST
Source: Citi
6. a) Policy Rate Normalization
The macroeconomic approach to analyze the policy rate normalization process is based on a well-established monetary policy rule
known as the Taylor rule which suggests the equilibrium policy rate is a function of the steady state policy rate, real economic output
gaps, and inflation rates gaps from long term growth and inflation potentials and targets. By incorporating forward looking
macroeconomic forecasts such as growth and inflation rate forecasts to assess near term output and inflation gaps, depending on the
direction of the gaps, widening or narrowing, the Taylor policy rule provides an approximation of an equilibrium policy rate
normalization trajectory on how the central banks balance the competing monetary goals in setting an appropriate level of monetary
policy rate. As the economy currently is at the trough of an economic down cycle, and the policy rate is at record low, a gradual
revival in aggregate demand and hence economic growth will begin to narrow the output and inflation gaps as macroeconomic
activities are gradually approaching toward near term capacities and targets. Central banks would begin to consider policy rate
tightening as the diminishing output and inflation gaps from potential will increase market expectation of inflationary pressure.
Rational investors will begin to expect higher yield and return compensation for higher income growth, inflation, and policy rate
expectation, and this higher expectation will translate into a sharp upward repricing of the short rates. In the two months prior to the
2004-2006 rate hike cycle, the 2y UST yield jumped nearly 1%, the yield slope between the 2s and FFs jumped from 0.57% in Mar
2004 to 1.53% in May 2004, ahead of the start of the rate hike in June 2004.
b) Short Rate Normalization Paths
The charts below show the path of short rate normalization is highly dependent on that of policy rate normalization. 1) An anticipated
rate tightening will drive the market to begin to normalize the short rate prior to rate hikes. In the last two rate hike cycles, the market
has already normalized 30% of the eventual moves in the short rates when the rate cycles began. 2) A gradual steady fine tuning
policy rate normalization process such as in rate hike episode 4 (2004-2006) during which 17 25bps rate hikes within 24 months
policy cycle dictated a slow and smooth short rate normalization path. On the other hand, the 7 rate hikes ranged between 25-75bps
within 13-month tightening cycle in Episode 2 (1994-1995) brought about a more volatile path of short rate normalization. The short
rate even overshot the normalization path before the rate hike cycle ended. While in Episode 1, rate hikes ranged between 12.5bps to
1%, the pause in the middle of the rate hike cycle wrongly gave the market a policy ending signal, and the short rate normalization
path reverted, only to pick up with accelerated speed and heightened volatilities. This suggests if central banks would like to see a
steadier short rate normalization and to reduce market volatilities, policy makers should give regular and unambiguous signals to the
market in their policy communiqués to guide market expectation of policy rate normalization.
8. 3. The Long Rate Dynamics
Earlier we established that across the various previous rate hike cycles, the longer rates such as the 10y UST yield rose, on average,
only 1/3 in the magnitude of the eventual policy rate normalization. This rise in long term rate is quite modest compared to the rise in
short term rate we examined earlier, leading the short and intermediate curve to bearish flattening. One may ask, why is the rise in
long rate relatively modest when policy rate tightens? What drives this relatively long term yield stickiness? There are various
conventional explanations, and the relative long term yield stickiness during rate tightening cycles is largely a recent phenomenon.
a. Diminishing inflation expectation
Even though longer rate movements are not as sensitive to policy rate normalization during rate hike cycles, the influence of the
monetary policy may also not be underestimated. In particular, monetary policy credibility, especially in its effectiveness in
controlling inflationary pressure in an economic up cycle, can influence on the level and rise of long-term rates via its impact on
inflation expectations and term premia.
Conventional models in general decompose long-term rates into the following components: 1) the expected short-term real interest
rate; 2) inflation expectation; 3) a combination of term, liquidity and risk premia associated with the bonds’ maturity, issuer, and
market conditions. As previous section focused on the short term rate dynamics, here we focus on the second and third components of
long term rates. We support the conventional argument that a well-established monetary policy credibility is a powerful tool in
anchoring market expectation of inflation and risk premia. If policy rates are expected to return to the neutral level once any cyclical
and inflation shocks have run their course, and if the market believes that long-term inflation expectations are well anchored with
monetary tightening policies, a diminished perceived inflation risk, and with lower associated volatility of prices and output, during
central banks’ rate tightening cycles, are key contributors to the stickiness of long-term yields via a narrowing in inflation and risk
term premia as investors demand lower term premia to hold long-term securities. The graph below demonstrates that in periods
preceded the rate hike cycle of 2004-2006, inflation expectation gap (the difference between breakeven rates and core PCE) exceeded
1%, followed by a gradual moderation when the rate hike cycle began and eventually that inflation expectation gap fell to zero by the
end of the policy cycle. That is, the rate tightening was effective in reducing expectation gap until inflation expectation became
consistent with realized inflation rate.
9. Data source: Bloomberg
b. Shift in Portfolio Preference
In addition to the repricing of long term yields with moderating inflation risk and term premia in an economic up cycle coincided with
a rate tightening cycle, long term yields are also influenced by portfolio shifts by changing investor demands. In facing with
moderating inflation risk and term premia due to stabilizing output and prices, long term real yields may rise if nominal yields are
deflated by lower inflation risk and term premia, we expect to see a demand shift from yield-focused private-sourced investors
towards longer-dated securities in search of higher yields. Recent stronger than expected bids for long term US Treasury auctions
suggest that this demand shift is already underway. This shift in portfolio preference towards longer-dated securities in a rate hike
cycle can be attributed to two key investor rationalities:
1) Enhancing portfolio returns: In anticipating an overall rise in interest rates and higher costs of borrowing, investors’ desire to
enhance portfolio return would lead to increase investment in higher yielding securities. Within the rates market, while the slope of the
curve is still reasonably steep and provides attractive rolldown in the early cycle of the rate tightening, the desire for higher yields
outweighs the concerns for duration risk if investors expect policy rate normalization process to be gradual, leading to extending out
along the curve to invest in longer-dated securities. The yield-focused shift in portfolio preference hence increases demand for longer-
dated securities, and helps drive the longer term yield lower and curve flatter as the rate tightening continues.
10. 2) Cushioning price volatility: Bonds with yields well above prevailing interest rates are sometimes called cushion bonds, because
these bonds help to cushion against falling prices when rates rise. All factors equal, bonds with higher yields will be less volatile than
bonds with low yields due to the convexity of the price/yield relationship. In anticipating a rising interest rate environment, investors
would also shift portfolio preference towards securities with relatively lower yield volatility by seeking above prevailing yields. We
expect to see higher coupon rate bonds to outperform lower coupon bonds given the same maturity structure due to their more
desirable duration and convexity properties in immunizing a rising interest rate environment.
The demand for long term treasury securities from official capital flows from countries with foreign reserves accumulated in US dollar
remains one of the important factors compressing term premia and flattening the yield curve in recent years. These types of investment
flows toward long term Treasury securities are relatively price inelastic and remain substantial, most notably created the so called
“bond conundrum” phenomenon during the 2004-2006 rate hike cycle. Although there were occasional discussions of the desire of
Asian countries to diversify their reserve accumulation away from US dollars or US Treasury securities, given their large current
account deficits with the US and their reliance on trade with the US market, recent strong bids from indirect bidders in US Treasury
auctions suggest that any such discussions of diversifying away from US Treasury securities remain largely rhetorical.
4. The Curve Dynamics of the Rate Hike Cycles
We observe the changing curve dynamics of the 2s10s slope are sensitive to the starting slope of the curve in the last four episodes of
rate hikes as shown in the graph below: 1) If the curve started off relatively flat, such as in Episode 3 where the 2s10s curve was only
27bps when the rate hike cycle began, a majority of the changing curve moves was largely followed by bearish parallel moves first,
the ending dynamics were of corrective bullish flattening led by the long end of the curve; 2) If the curve slope has steepened prior to
rate hike cycles as in Episode 1, 2, and 4, then the curve dynamics will be dominated with bearish flattening in the following order: a)
An initial period of bearish parallel moves in anticipating of overall higher interest rate environment; b) Protracted period of gradual
bearish flattening moves led by front end with higher policy rate expectation punctuated with bearish parallel shifts driven by positive
growth factors and supply concessions; c) Corrective bullish flattening moves led by long end as the short end is anchored by higher
rate expectations and the long rates are driven lower by lower inflation risk premia and shift in portfolio preference for longer-dated
securities; d) Corrective bullish/bearish steepening if rates overshoot at the end of the rate cycles.
11. Curve Dynamics
2.5
2
2s10s Slope (%)
1.5
1
0.5
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27
-0.5
-1
Rate Hike Schedules
Episode 1 Episode 2 Episode 3 Episode 4
Data source: Bloomberg
5. Summary
As we have attempted to establish so far the next sustainable move in the US Treasury yield curve is of a protracted bearish flattening
dynamic prior to and during rate hike cycles, With those said, one also needs to differentiate between policy tightening from policy
rate hiking in coming months given many of the unorthodox liquidity facilities used by the Fed in this credit easing cycle. The Fed can
tighten by unwinding many of its easing programs before it begins hiking interest rate. In fact, the Fed has begun to do so. The Fed’s
balance sheet shows its liquidity facilities have shrunk from a peak of $1.6tr in Dec 2008 to $366bn in October 2009, although certain
programs such as TALF remains in place to support consumer residential and commercial asset-backed securities. The Fed’s exit
strategy has begun.
In summary, we expect to see a sharp upward re-pricing of the short end as soon as the market expects the risk of policy tightening
move drawing near. Once an eventual turn of the cycle into a tightening one, we should then expect protracted parallel shifts higher in
yields, punctuated by smaller corrective bull flattening biases. The net effect is a substantial flattening of the curve and higher rates,
but the actual curve dynamic we shall likely see is bull flattening with parallel bearish moves.
12. References:
Bloomberg, http://www.Bloomberg.com
The Federal Reserve Board, http://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
Mark Schofield, “Duration and the Yield Curve – the Slow Process of Normalisation of the Term Structure,” The International Interest
Rate Strategist, Citi, 21 August 2009.
John B Taylor, “Monetary Policy Rules,” NBER-Business Cycles Series, Vol 31, 1999.