On term structure of interest rates over the 2007 to 2013 period in the US

Introduction
For the financial field, interest rates are probably the most important part because they represent the time discounting tool used in pricing all the market securities. Companies depend on the interest rates too when calculating the cost of capital for potential future investments. However, it is crucial to find the appropriate technique that should be used, for example, in pricing all the financial assets, in making decisions regarding portfolio management and in assessing the expectations of the real economy and the future interest rates. The appropriate technique is the term structure of interest rates defined as the relation between interest rates and time to maturity. The basic interest rates defining the term structure are spot rates, which are the return given by zero coupon assets (such as Treasuries in the US or Gilts in the UK), thus the term structured is derived from the yield curve of the zero coupon bonds. The yield curve is simply the nominal yield (or return) to maturity of various assets that have different time to maturity but similar features (liquidity or credit risk, for instance). Spot rates differ from yields to maturity because the former correspond only to a specified maturity date and the asset on which they are computed makes a single payment at the maturity date and nothing else before of thereafter. One example of this kind of assets is the zero coupon bond, which does not pay any interest. There are bonds that do not pay interest (coupon), but only because they have been stripped by financial institutions (usually banks) and repac kaged as zero coupon bonds. These types of securities are trading at a discount and they have the tendency to fluctuate more often that coupon bonds. This paper tries to determine how the term structure of the interest rates has changed since the onset of the financial crisis by looking at the US data and it will continue as follows: section 1 will provide an overview of the US economy during the 2007-2013 period, then the changes in interest rates over the same period will be outlined and the potential drivers that were behind these changes will be discussed. The last part of the paper will conclude.

Overview of the US economic condition over the 2007-2013

Since 1871, the United States has been the world largest national economy, contributing to the world GDP with about 30% on average since 1960. Many people believe this position is now taken by China, mainly because US experienced the biggest financial crisis in the last decades. It all started in August 2007 with a liquidity crisis when financial institutions stopped lending to one another, lacking thrust as a result of losses they had incurred from subprime mortgage securities. In December 2007, National Bureau of Economic Research officially stated that the US economy was in recession. Soon after the share prices and the home prices fell, the fuel costs increased as well as the loss of confidence among investors. The bankruptcy of Lehman Brothers in September 2008 was the starting point of the global recession, which turned out to be the biggest global crisis since the Great Depression, characterized mainly by a steep drop in international trade, a decline in commodity prices and high unemployment figures. The main causes were the subprime mortgage lending both US and other Western European countries, which led to a real estate bubble and the failure of financial regulation. Particularly for the US, the financial crisis had disastrous consequences. The output fell by a cumulative 4.1%, most of it occurring after September 2008. Inflation initially rose because of the high prices in commodities, but after these prices declined in 2008, inflation slumped as well and has stayed at very low figures since. Unemployment peaked 10.1% in October 2009 with an increase of 5.1%. Consumption fell also, but less than the

rate of GDP, while business investment and residential investment registered a fall by more than 10% in just two quarters and 10% over thirteen consecutive quarters, respectively. The US economy has started an upward trend again since mid-2009, but it has only grown at an average annual rate of 2.3%. However, stock market is now at record high (S&P 500 Index has reached 1810.65), the unemployment has fallen to 7%, personal consumption and private investment have risen. The banks are healthier than before as well. Most of this recovery is a result of the monetary policy developed by the Federal Reserve and Government decisions, which decided to bail out the biggest financial institutions that were on the brink of collapse in 2008. This was a necessary condition in the absence of private-sector lenders worried about the economic situation. Federal Reserve has decided to cut interest rates near zero and to inject money in the economy in order to raise the amount of lending and encourage spending. The policy is called monetary easing and refers to buying assets (government bonds) by the central bank with new printed money. Interest rates were set to zero to bolster consumption and to encourage lending, but combined with quantitative easing, they have a significant impact on the short and long-term interest rates in the financial market. In turn, changes in the term structure of interest rates will be analyzed and their causes outlined in more details.

Changes in the interest rates and potential drivers of them over the 2007-2013 period
The term structure of interest rate has changed substantially during and after the financial crisis. The factors responsible for the change are the Federal Reserve aggressive response to financial crisis (expressed by lowering federal funds rate (to a range between 0% and 0.25%) and quantitative easing) and the market expectations about the future. It is important to note that long term interest rates are usually higher than short term rates because the former imply a bigger risk for investors due to the uncertainty of the future. This difference can be amplified or reversed when the investors expectations about the future are positive or negative. In the Figures 1 to 3, the term structures of interest rates, or yield curves, are plotted for the period 20072012 and it can be seen that, for the years after the onset of the crisis, the changes are dramatic. All three figures show that soon after the credit crunch, the yields have dropped significantly as a result of heavy demand of riskaverse investors looking for security and of the measures undertaken by the Federal Reserve. In order to understand why the yield curve is much lower nowadays than in the past, the case of the longerterm yields is discussed. Chart 2 from the appendix is useful to see how a ten-year treasury yield is constructed. There are three components that form the basis of the yield: one refers to expected inflation over the 10-year period, another captures the term premium and the last one looks at the expected real interest rate. From the chart, it can be seen that much of the decline in yield is because of the steep fall in term premium, but the interest rate has a role too. The Federal Reserve made it clear that it will fight against inflation and it has been seen that the inflation rate was low and stable over the last 5 years. In addition, the nominal interest rate, because this is in effect what the central bank is controlling, is at record low and near zero and the intention is to keep it that way in the future, even after the unemployment in the US falls below 6.5% (this threshold has been set at a first goal by the Federal Reserve). Lastly, the term premium has decline as well because 10-year government bonds are now perceived as a less risky investment, because the volatility of the yields declined thanks to near-zero short term interest rates, which are intended to remain low in the future. Moreover, 10-year bond prices have become more negatively correlated with the stock prices and they are used as a hedge method against more risky assets. Term premium has been affected also by the tendency of investors to put their money in safe havens during the financial turmoil. The prices of treasuries rise sharply during such purchases and lower the yield of the asset. On the same note, another reason for a lower term premium is given by the Federal Reserve asset buying program, which also put pressure on the long term yields and lowered them.

Figure 1: Comparison between the term structures of short-term interest rates over the 2007-2012 period1

Yield Curve
6 5 4 3 2 1 0 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 2007 2008 2009 2010 2011 2012

Figure 2: Comparison between the term structures of medium-term interest rates over the 2007-2012 period

Yield Curve
6 5 4 3 2 1 0 1 2 3 4 5 6 7 8 9 10 2007 2008 2009 2010 2011 2012

The data in these figures are the spot rates for Treasuries with different time to maturity from the Federal Reserve of the United States website : http://www.federalreserve.gov/. The horizontal axis represent the years to maturity, while the vertical axis gives the yield in percentage points.

Figure 3: Comparison between the term structures of long-term interest rates over the 2007-2012 period

Yield Curve
6 5 4 3 2 1 0 10 12 14 16 18 20 22 24 26 28 30 2007 2008 2009 2010 2011 2012

Judging after the yield curve for long-term interest rates in Figure 3 the strategy undertaken by the Federal Reserve, i.e. keeping long-term yields low, has paid off so far. If Chart 1 in the appendix of this paper is examined, it can be noted that the same situation is present in other major developed economies around the world. The movements in the yields of ten-year government bonds from the US, UK, Canada and Germany are significantly correlated. They are all sitting at roughly 2% at the moment, sign that policymakers share the same view in regard with the economic developments of the past years. The explanation consists of similar expectations in these countries about the inflation and real interest rates, but most importantly the term premium of the longer-term government bonds. The situation, however, is different in Japan, but that is because of its policy regarding inflation. Japan has been experienced a long period of deflation and now radical measures are undertaken to reverse the trend.

Conclusion
This paper was intended to provide an insight regarding the changes in term structures of interest rates during the 2007 to 2013 period in the United States. It showed that these changes were caused by the financial crisis and the measures undertaken by the Federal Reserve to offset the impact over the US economy. The main factors that drive the term structure of interest rates to change are the expected inflation, the expected real interest rates and the term premium required by the investors to be compensated for the future uncertainties. In addition, Federal Reserve actions such as the asset buying program (quantitative easing) and a longterm oriented low rate policy, as well as the tendency of investors to look for safe-haven securities have put pressure on the long term interest rates and have changed the term structure.

Appendix

References
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