With the funds rate stuck at zero for nearly four years, the Federal Reserve (Fed) has used a variety of unconventional policy tools in an effort to push longer-term interest rates lower. For example, the Fed has deployed large scale security purchases (quantitative easing) in order to remove supply from the market and push up prices. It has also used communication to signal that the funds rate is likely to remain very low for the foreseeable future. We think these actions affect markets in a variety of ways, and also that some of their effects may overlap (for a more detailed discussion see “QE: Going under the Hood”).
One channel through which unconventional policy might work is the impact of communication on uncertainty about policy rates. Bond yields at different maturities are not independent of one another, or determined primarily by maturity-specific supply and demand. Rather, the yield curve should be thought of a series of forward rates strung together into an internally consistent whole. The basic building block of the yield curve is the short-term interest rate — such a Treasury bill rate or the federal funds rate. In effect, the yield curve can be thought of as a function of three factors:
- the current level of short-term interest rates,
- the expected path of short-term interest rates over time, and
- uncertainty about the future path of short-term interest rates, which is the source of risk premium in the yield curve.
In our view, the Fed’s communication about how long the funds rate will remain near zero — what it refers to as its “forward guidance” — has lowered market uncertainty about the future path of short-term rates, and thereby reduced risk premium in the yield curve. We measure investors’ perceived uncertainty about short-term rates from the options market (in particular from “swaptions,” or options on interest rate swaps).
Exhibit 1 shows the term structure of interest rate volatility at two points in time: the average level during 2009-2010 (when the funds rate was also near zero) and the most recent level. The chart shows that implied volatility for a one-year swap rate has declined for all points along the curve, but most dramatically for points one to three years forward. This should be interpreted as a greater degree of confidence about the trajectory of short-term rates over the next few years.
Economic theory suggests there should be a close correspondence between uncertainty about the future path of short-term rates and the risk premium in the yield curve. And as it turns out, we also observe this in the data. The second exhibit shows the implied volatility — which again can be thought of as a proxy for market uncertainty — for the one-year swap two years forward, and compares it with a standard measure of the risk premium in the 10-year Treasury yield (the latter is derived from a model developed by Federal Reserve Board economists). The risk/term premium declined sharply over the last year, and is now approximately -75 basis points.
As Exhibit 2 makes clear, the decline in the risk premium has had a very tight correlation with implied volatility over the last four years, strongly suggesting that reduced uncertainty has helped drive longer-term interest rates lower.