Whatever the Fed decides to do, it hasn’t got much to do with interest rates…PLUS the latest release from DJ Dr Fish

Term structure theory can be complex to understand, but there are some simple restrictions that must be obeyed.

One simple fact is that a 10 year coupon bond is made up of a lot of little zero-coupon bonds with varying maturities from a few months all the way out to 10 years. It must be that the price of the 10year coupon bond must equal the sum of the little zero-coupon bonds or otherwise there is an arbitrage available. No-arbitrage is a pretty strong feature of the financial markets.

Two little components of 10 year bond are the September 2015 Tbill and the December 2015 Tbill. These are attracting a lot of attention since they are the focus of whether the US Federal Reserve decides to tighten this month or in December. The no-arbitrage condition enables us to calculate the impact on the 10 year yield of whether the Fed decides to raise rates by 25bp in September or wait until December 2015 using a calculator. It turns out that the marginal impact on the 10 year yield of the Fed waiting until December versus moving in September is 0.006%…

WHAT, DID I SAY ONLY 0.006% ?!?!?! Try telling this to the US Bond market! The following Bloomberg grab shows Friday night’s 10 year yield response to the US Employment number that is supposed to guide the Fed to decide between moving in September or waiting until December,

Lo and behold, just take a look at the 20:30 (Singapore time) Employment announcement’s impact on 10 year bond yields. The initial impact was a fall of -0.025%, followed by a jump of 0.06% over the next few hours and then a decline of -0.03% to finish the trading session almost back where it all started. All this activity, ostensibly to do with whether or not the Fed is hiking in September or December, the effect of which a handheld calculator tells us should be no more than 0.006%.

Something else must be going on in the markets other than just guessing the Fed. Did this create an arbitrage opportunity? Actually, no, because the whole term structure of interest rates responded to the announcement in tandem. But clearly the markets’ assessment of future interest rates cannot be based solely on the impending Fed action.

The risk premium assigned to bond risk is probably at work here. The market has been living with a very steep yield curve for many years, attributing a high risk premium to the multiple fears of inflation and aggressive Fed tightening. Both of these risks seem over-oaked (as they say in the wine industry) – inflation is ambling along at 0.3% per annum and the Fed-speak is sounding like a “Clayton’s” – the rate hike you have when you are not having a rate hike. Bond investors may be in for a very positive end to 2015.


DJ Dr Fish’s “One Fish Mix, Two Fish Mix, Red Fish Mix, Blue Fish Mix” has just been released on Soundcloud.com. Check it out here