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4) (40 points) The Conundrum, the Taper Tantrum and Conundrum #2. In class we discussed the
Conundrum that occurred in 2006. The Fed was clearly in a tightening cycle and raised the target for the
federal funds rate 17 times in a row. The target went from 1% up to 5.25%. Given the pure expectations
theory of the term structure (PET), longer rates should have followed suit, but they didn't! This is the
conundrum! See graphic below.
a) (5 points total) Using the links below, calculate the slope of the yield (defined as SYC = i GS10 minus i
GS3M) in May of 2004 and in December of 2006.
Click Here for monthly data on the GS10
Click Here for monthly data on the GS3M
MAY 2004.......SYC = 4.72% - 1.04% = 3.68%
DEC 2006........SYC = 4.56% - 4.97% = -.41%
Using your calculation above, draw two yield curves - one representing the conditions in May of 2004 and
another with the conditions as they were in December of 2006 (on the same graph). Please label diagram
completely.
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b) (5 points) Using PET, offer an explanation as to why the GS10 behaved the way it did during this period.
i10 = (i1 + i12e + i13e + i14e + i15e + i16e + i17e + i18e + i19e + i110e) / 10
WE KNOW THAT THE FIRST FEW TERMS WERE GOING UP GIVEN THAT THE FED WAS
OBVIOUSLY IN A TIGHTENING CYCLE - SINCE THE GS10 ACTUALLY FELL, IT MUST BE,
USING PET, THAT THE LATTER TERMS WERE FALLING TO MORE THAN OFFSET THE
NEARER TERMS THAT WERE RISING - PERHAPS INVESTORS EXPECTED A RECESSION
IN THE FUTURE, CONSISTENT WITH LOWER EXPECTED SHORT RATES WELL INTO
THE FUTURE.
c) (5 points) Using the liquidity premium theory of the term structure, offer an alternative explanation as to
the behavior of the GS10 during this period.
i10 = [(i1 + i12e + i13e + i14e + i15e + i16e + i17e + i18e + i19e + i110e ) / 10] + lt
USING THE LIQUIDITY PREMIUM THEORY, THE TERM PREMIUM FELL,
REFLECTING THE FACT THAT THE PROBABILITY OF A CAPITAL LOSS
AS IN HIGHER INTEREST RATES WAS LESS GIVEN THAT CHINA AND
OTHER COUNTRIES THAT WERE SAVING (INDIA, SAUDI ARABIA, ETC)
WERE BUYING UP OUR GS10'S KEEPING THE PRICE HIGH AND
THEREFORE, RESULTED IN A LOWER TERM PREMIUM... SO MUCH SO
THAT IT MORE THAN OFFSET THE HIGHER EXPECTED SHORT RATES IN
THE NEAR FUTURE.
We now move onto another episode in history and that is the Taper Tantrum! See the excerpt below from:
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Lessons from the Taper Tantrum
by Christopher J. Neely
Events following a policy announcement last summer afforded researchers an
opportunity to confirm previous findings of the effect of such bond purchases on asset
prices. First, positive economic news in the spring of 2013 led Federal Reserve
Chairman Ben Bernanke to testify to Congress on May 22, 2013, that the Fed would
likely start slowing—that is, tapering—the pace of its bond purchases later in the year,
conditional on continuing good economic news. This testimony laid the groundwork for
the June 19 press conference in which the Chairman optimistically described economic
conditions and again suggested that asset purchases might be reduced later in 2013:
"
The graphic below shows the reaction to this June 19th press conference - this is the beginning of the
TAPER TANTRUM!
d) (5 points) Use the link to the June 19
press conference below to identify exactly
what Ben Bernanke said that caused such
a significant movement in GS10 and the
value of the US dollar! (hint - see page 5!)
June 19, 2013 Press conference
write down what he said exactly here (you
can copy and paste if you want!
If the incoming data are broadly
consistent with this forecast, the
Committee currently anticipates
that it would be appropriate to
moderate the monthly pace of
purchases later this year. And if
the subsequent data remain
broadly aligned with our current
expectations for the economy, we
would continue to reduce the
pace of purchases in measured
steps through the first half of
next year, ending purchases
around midyear.
e) (5 points) We talked in class how
having a press conference after an FOMC
meeting could be 'handy' if the Fed Chair
needed to practice damage control or clarify something that was part of the FOMC statement that is
released shortly before the Fed Chair press conference. As it turns out, the FOMC statement was not the
market mover as they explicitly stated that they would continue QE3. See excerpt from the statement
below:
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'To
support a stronger economic recovery and to help ensure that inflation, over time, is
at the rate most consistent with its dual mandate, the Committee decided to continue
purchasing additional agency mortgage-backed securities at a pace of $40 billion per
month and longer-term Treasury securities at a pace of $45 billion per month. The
Committee is maintaining its existing policy of reinvesting principal payments from its
holdings of agency debt and agency mortgage-backed securities in agency mortgagebacked securities and of rolling over maturing Treasury securities at auction.'
So it appears that Ben Benanke used the press conference, rather than the FOMC statement, to give explicit
forward guidance on QE3 - this is your answer from part d) of this question. He also used the press
conference to clarify what the implications of this (possible/probable) tapering would have on the future
path of short term interest rates. In fact, he was trying really hard to separate the idea of tapering and the
influence of short term interest rates moving forward. How did he do this, what did he say (hint: page 6)
write down what he said exactly here (you can copy and paste if you want!
I will close by drawing again the important distinction between the Committee’s
decisions about adjusting the pace of asset purchases and its forward guidance
regarding the target for the federal funds rate. As I mentioned, the current level of
the federal funds rate target is likely to remain appropriate for a considerable
period after asset purchases are concluded.
f)(5 points) Using PET and the graphic of the reaction of the GS10 to the press conference, why exactly do
they call this a Taper tantrum?
i10 = (i1 + i12e + i13e + i14e + i15e + i16e + i17e + i18e + i19e + i110e) / 10
Bernanke made it very clear that tapering and the expected path of short rates are
two different things so since the expected path of short rates does not and should not
change, investors are having a taper tantrum - the GS10 should not have reacted
but it did!
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g)(5 points) Given the Taper Tantrum in 2013, relatively new research suggests that it will likely happen
again when the Fed gets off the zero bound. In a WSJ article titled:
"Last Year’s Taper Tantrum May Have Been Taste of the Future, Paper Says"
an excerpt will help:
“The Fed may have succeeded in 2013 in convincing market participants that slowing the
pace of bond purchases is a separate decision from decisions about the path of future
interest rates,” the economists wrote. “Our analysis suggests that whenever the decision
to tighten policy is made, then the instability seen in summer of 2013 is likely to
reappear.”
As we know, the Fed is off the zero bound and has signaled that they will be raising interest rates further
this year. Given the current rate on the GS10 (click HERE), are we in the midst of another Taper Tantrum
as defined as investors 'freakin out' over the prospect of future interest rate hikes? Why or why not?
no, so far so good, NO TANTRUM AS THE GS10 IS VERY WELL BEHAVED - PERHAPS GIVE
CREDIT TO THE YELLEN FED WITH EXCELLENT FORWARD GUIDANCE!
h (5 points) Some people (me) are referring to the most recent developments as conundrum number 2. That
is, the Fed has entered a tightening cycle and the GS10 seems to be going the opposite way. What has
happened to GS10 this year so far - use the value on the GS10 from 12/31/2015 and compare to the value
of the GS10 on April 7, 2016 (click Here for the daily data). What could explain this reality??
ON 12/31/15 GS10 = 2.27%
ON 4/7/16 GS10 = 1.70%
RATES ON GS10 HAS FALLEN THIS YEAR - TWO POSSIBILITIES: 1) FORWARD
GUIDANCE - THE FED HAS CAME OUT WITH DOVISH STATEMENT AFTER DOVISH
STATEMENT - LOWERING THE EXPECTED PATH OF INTEREST RATES - 2)
LOWER/NEGATIVE TERM PREMIUM, GIVEN NEGATIVE INTEREST RATES ABROAD - A
LOT OF DEMAND FOR US ASSETS SUCH AS THE GS10 - SAME IN SPIRIT AS QE OR
DEMAND FROM CHINA - THE PROBABILITY OF A CAPITAL LOSS (HIGHER RATES) IS
EXTREMELY SMALL! PROBABLY A LITTLE OF BOTH!!
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