Harvard University Economics 1813 “The Indebted Society” The Yield Curve Ronald W. Sellers, Chairman & CEO Atlantic Asset Management, L.L.C. October 29, 2007

2 Outline 1. Yield Curve – What is it? 2. Importance 3. Shape 4. Changes 5. Forecasting 6. Summary Data sources: Federal Reserve, Bloomberg Financial, Grandfather Economic Report

3 Yield Curve – What is it? Bloomberg Financial Definition: Yield Curve. A chart consisting of the yields of bonds of the same quality but different maturities. This can be used as a gauge to evaluate the future of interest rates. An upward trend with short-term rates lower than long- term rates is called a positive yield curve, and a downward trend is called a negative or inverted yield curve.

4 Yield Curve – What does it look like? Yield curves are derived as the best fitted curves (cubic spline) to daily yield data on all Treasury bonds. US Treasury Bond Yields 9/30/87 through 9/30/07 Monthly Averages

5 Importance of the Yield Curve Gives the term cost of money (before credit risk) Provides discount rates for future expected cash flows Basis for pricing fixed-income securities and valuing all debt Real-time market driven phenomenon

6 Shapes of the Yield Curve

7 Yield Curve Shape Determines profitability of borrowing short and lending long Reflects the tradeoff between yield and volatility in the market Anticipating shape changes is key to many hedge fund & other investment strategies What are characteristic change patterns?

8 2s, 5s, 10s Butterfly Trade

9 Yield Curve Change Patterns Three – factor analysis of yield curve shape Explains (on average) 95% of bond price change Level 75% Steepness 15% Curvature 5%

10 What changes the Yield Curve? Changes in term distribution of the supply and demand for money (lending and borrowing activity) Federal Reserve Inflation expectations Volatility Oil prices Arbitrage

11 Historical Yield Curves vs. Bond Volatility Bond Volatility – Government Bond Returns

12 What has changed the Yield Curve? Principal Events Federal Reserve increases Funds Rate 17 times Stock Market crash October 1987

13 What has changed the Yield Curve? Principal Events Russia defaults on debt, Fall 1998 Saudi Arabia frees up the price of oil

14 The Indebted Society Total U.S. Debt - $48.4 Trillion

15 Total US Public IG Bond Market $9.7 Trillion

16 Events and the Yield Curve $ Impact on Bonds and All U.S. Debt Impact in $ Billions Bonds ($9.7T)All Debt ($48.4T) 1.Federal Reserve 17 increases 5/04 – 9/ ,540 2.Stock Market crash 10/ ,320 3.Russia debt default Fall ’ Saudi Arabia frees oil prices, 1 st Qtr. ’ ,420

17 Forecasting the Yield Curve I. Traditional approaches  Mean reversion  Fed watching  Matching curve shape to economic environment  Forecasting inflation II. Macro economic analysis combined with pattern recognition of short-term variables  Atlantic’s LAB Model

18 LAB Econometric Model Variables Labor Market Capital Market X Optimizer Duration Implementation Slope Level Short Term Variables Equilibrium Level for Real Rates Cyclical Variables Level and Slope Model TS/Multiple Regression Solution Forecast Change in Rates Portfolio Management

19 Forecast Accuracy Correct Forecasts vs. Total Forecasts Econometric Model January 1987 to September 2007 Correctness with respect to forecasting the direction of interest rate changes Includes Back Testing for Early Years

20 Yield Curve – Alternatives 1. Treasury Coupon Curve  Current on-the-run coupon bonds 2. Treasury Spot Curve  ‘0’ coupon bonds  Pure discount rates for maturities and durations 3. Treasury Forward Curve  Implied forward rates between maturities for given time horizon 4. LIBOR Swap Curve  The fixed rate at each maturity that can be exchanged for a floating rate  London Interbank Offered Rate, AA-rated, 1-month to 30-year maturities

21 Summary The Yield Curve is probably the most important factor in the capital markets and possibly the economy. The Fed tries to manage it and everyone tries to forecast it. Its shape is key to the profitability of many businesses and many investment strategies. Everyone is affected by its level and shape change every day. Nothing in the economy is watched closer on a minute by minute basis.

22 Questions 1. As we have seen, the Indebted Society is characterized by unprecedented levels of government, corporate and household debt. What determines the interest rate that these borrowers pay for their debt? 2. Would we expect the interest rate to be the same for both short-term and long-term debt? 3. Do borrowers care more about short-term or long-term interest rates as they decide whether and how much additional debt to assume? Does it depend on which category of debtors (e.g., homebuyers vs. Federal government)?

23 Questions 4. What is the current credit/mortgage crisis all about? ― World awash in cash ― Overzealous lending in subprime mortgages ― Irrational exuberance securitizing these loans ― Blind financing with short term funds to purchase longer term securitized product

24 Short Term Rates & the Current Credit Crisis

25 Yield Curve and the Economy Steep yield curve generally goes with an economy that is expected to strengthen or an inflation rate that is expected to rise. Often that means that the economy is currently weak and the current inflation rate is low. For example, in 2003, the economy was weak, and the inflation rate was very low; the yield curve was steep because the economy was expected to strengthen and the inflation rate was expected to rise from its very low level. Flat or inverted yield curve [conversely] generally goes with an economy that is expected to weaken or an inflation rate that is expected to fall. Again, that often means that the current situation is the opposite. In mid-2006, for example, the inflation rate was high by recent standards but was expected to fall, which was one reason for the inverted yield curve. Today’s yield curve is a rather unusual beast. Overall, it is upward-sloping but flatter than normal. The flatness reflects an expectation that the economy may weaken (a possible recession) and probably that rising food and energy prices will eventually level off and stop pushing up the general inflation rate. However, the curve is flatter – even inverted – at the short end and steeper at the long end. This pattern seems to reflect a combination of concerns about a weak economy in the near term ( ) and concerns about possible inflation in the longer term. In particular, since the overall world economy is strong, markets may be concerned that a recession in the US could weaken the dollar dramatically and thereby risk higher inflation over the longer time frame. One unusual feature of the yield curve we have seen in recent weeks is that, even though the short end in general is flat or inverted, the very short end – between 3 months and 6 months – has been upward-sloping. This pattern seems to reflect a premium on liquidity. Financial institutions are uncertain about cash demands and therefore want assets that can be quickly and reliably converted into cash. They are therefore willing to accept lower interest rates on such assets, in particular 3- month Treasury bills. Andy Harless, PhD November 13, 2006