The transmittance of changes of the prime rate to the long end of the yield curve – and why it actually does not work

Table of contents

1. Introduction

2. The Yield Curve: Basics

3. Theories of the Transmittance of the Yield Curve
3.1. Fisher’s Theory of Interest
3.2. Hicks’ Liquidity-Preference-Theory
3.3. Culbertson’s Segmentation Theory
3.4. Preferred-Habitat-Theory
3.4. Summary

4. Description of the Actual Situation

5. Reasons for the Deviation from the Theories
5.1. Expectation-Determined Factors
5.2. Liquidity Factors
5.3. Structural Factors
5.4. The Comprehension of the Central Bank

6. Conclusion

References

1. Introduction

In February 2005, Alan Greenspan, at that time Chairman of the Federal Reserve Bank of the USA, wondered why the long-term rates on the capital markets do not respond to the changes of the short term prime rates by the Fed (Hussla, G.A., 2005). National Central Banks change their prime rate to steer the economic situation and the inflation in their state. With their monetary policy, Central Banks aim at a sustainable, healthy economic situation (Hanweck & Shull, 1996, p. 22).

Central Banks change the prime rate expecting changes of the whole yield curve, which pictures in the most common model the interest rate structure from 3 months to 10 years maturity. Normally, by changing the short end of the yield curve, the long end of the curve will change, too – so the sourcing for the businesses becomes more expensive. This leads to that the businesses have to limit their investments, which causes macroeconomically a slower economic development (Brinkmann, 2005, p. 142).

In February 2005, Alan Greenspan was surprised that the yield curve did not show any response to six interest rate hikes since June 2004. The assumption to influence the yield curve and thus the economic situation did not occur (Handelsblatt, Feb. 2, 2005, p. 17). This situation has, two years later, not changed: the Fed raised their prime rate 11 more times to 5,25%, but the yield curve is inverted. On February 1, 2007, the interest rate for 10-years-treasuries was at 4,87% (Handelsblatt, Feb. 5, 2007, p. 36).

Why do the prime rate hikes not show any effects at the long end of the yield curve? Why did the assumptions for the hikes of the Fed not arrive the last three years?

2. The Yield Curve: Basics

Choudry defines the yield curve as follows (2004): “The yield curve is a graph that plots the yield of various bonds against their term to maturity. In other words, it is a snapshot of the current level of yields in the market” (p. 56).

So the yield curve gives an overview over the interest rates in the market. The rates are the result of demand and supply for capital on the bond markets. They are based on nominal interest, price and maturity of the bonds. Reliability remains out of consideration; the yield curve only consists of risk-free government bonds (Steiner & Bruns, 2002, p. 149).

The central banks, in this case the Federal Reserve Bank of the USA, can exert influence on the yield curve by changing their prime rate. The prime rate is the yield commercial banks have to pay for lending money for two weeks from the central bank. By raising this rate, the Fed makes the funding for the commercial banks more expensive. The banks transfer these higher costs to their customers, like businesses, individuals or other banks. (Choudry, 2004, p. 58) This trade among banks, called money market, is the base for the most common figure of the yield curve which starts with the 3-months-yield (Wöhe, 2005, p. 702).

3. Theories of the Transmittance in the Yield Curve

3.1. Fisher’s Theory of Interest

Changes at the short end of the yield curve are not directly transferred to the long end of the curve. There are several factors which influence the movements at the long end by changes of the prime rate. Many theories try to explain this transmittance. The most popular theory is the “Theory of Interest” by Irving Fisher. The main conclusion of this theory: “The rate of interest on a long term loan is virtually an average of the separate years constituting that long term” (Fisher, 1930, p. 313). This means that the long term rate can be explained via the future development of the short term rates. The long term rate can be described as the geometric average of all short term rates plus the reinvestment of the interest payment (Brinkmann, 2005, p. 46).

The theory is based on the assumptions that each economic entity has the same expectation of the development of the interest rates, that they are indifferent concerning the maturity and that markets without transaction costs exist (Fisher, 1930, p. 314).

Fisher’s theory justifies the very popular assumption that an increasing yield curve represents increasing short term rates. Contrariwise, a falling yield curve forbodes falling short term rates. These implications may not be wrong, but they are escapist. According to Fisher, a normal yield curve must be interpreted with permanent increasing short term rates, until it shows a quasi-constancy with minimal marginal increase of the rates at the long end of the curve. Furthermore, Fisher assumes that neither an income risk nor a capital risk exists. This means that the maturity of the bonds is irrelevant because investors see no risk in the future. (Brinkmann, 2005, p. 49).

3.2. Hicks’ Liquidity-Preference-Theory

A more realistic theory of the yield curve is Hicks’ theory. Its main conclusion is that investors will not buy a long-term bond without a risk-bonus. This bonus is finally the reason why the rate at the long end of the yield curve is normally higher than at the short end (Brinkmann, 2005, p. 50).

In his theory, Hicks presumes that decisions for the future are flawed with

insecurity, so an investor would only buy long-term bonds if his insecurity is compensated by a higher interest payment. If the investor’s insecurity is not compensated, he would only invest in short-term bonds to minimize the risk of losing his capital. Another assumption of Hicks is that an prefers capital safety to income safety. This means that it is more important not to suffer capital loss than to earn a higher yield.

Hicks also assumes, in contrast to Fisher, that investors have to pay transaction costs. For investing his money for ten years, the investor would pay much more transaction fees if he buys ten yearlong bonds than if he invests in one decennial bond (Hicks, 1947, p. 130 et sqq.). From this follows, that the long term yield can not be the geometric average of the short term yield – the short term rates have to be higher to compensate the transaction costs. Another fact which Hicks adds is that if the short term rate is lower than the transaction costs, no investor would buy short term bonds – he just wants to earn a net-income. (Brinkmann, 2005, p. 52)

John R. Hicks finally gives a clear answer to the transmittance of the yield curve: in the normal case, the yield curve is increasing because of the risk bonus which the investors expect. If the yield curve is inverted because of the economic situation, the long end of the yield curve has small volumes because the investors gain high, risk-free profits at the short end of the curve. Another fact is that the higher short term rates are, the faster an investor can amortize his transaction costs. At this point, the short end seems to get more and more attractive for investors. But a small demand for long term bonds causes falling prices and rising interest rates. By this transmission, the investors leave their short term investments and buy the more attractive long term bonds (Hicks, 1947, p. 130 et sqq.).

3.3. Culbertson’s Segmentation Theory

Culbertson’s theory describes the term structure for institutional purpose. It divides the market into a money market for banks and a capital market for insurances because of their different goals. Each investor, as well as each debtor, has his own, preferred maturity, which means that each market operator acts only in his preferred segment. This shows that the yield curve is an illustration of every single, autonomous part of the structure of the maturities. Culbertson also acts on the assumption of the matching maturities - the investor or the debtor wants to avoid every risk. He knows exactly how long he needs the capital or how long he can do without his capital as liquidity (Culbertson, 1957, p. 494).

[...]