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In 2015 the Fed funds rate was 0.24%, while the US Treaury 10-year government bond was 2.24%.

How is the spread determined? Is there a formula to determine the spread of the US-10 T-bond and the Fed funds rate?

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  • $\begingroup$ Examine quant.stackexchange.com/questions/20826/… $\endgroup$ – rrg Oct 21 '16 at 22:58
  • $\begingroup$ The 10 year rate is based on the markets expectation of where the FF rate will be during the next 10 years plus or minus a term premium. $\endgroup$ – noob2 Nov 21 '16 at 17:51
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It sounds like you understand how to do the math behind the calculation, simply, in your example, 224 basis points (yields on the US 10-year less the Fed Funds Rate of a meager 24 basis points, leaving the spread in your example landing nicely at a clean 200 basis points (2 percent).

3 KEY FACTORS DRIVING the 10-YEAR

  1. NET CHANGES IN THE U.S. MONEY SUPPLY vs. THE REST OF THE WORLD
  2. INTEREST RATE DIFFERENTIALS RELATIVE TO CURRENCY MOVEMENTS (PURCHASING POWER PARITY)
  3. THE SHAPE OF THE YIELD CURVE

ALL topics explained in further depth below.

Relative Liquidity Injection (into U.S. vs. EM and DM)

1) CENTRAL BANKERS IN U.S. vs CENTRAL BANK RESERVE ACCUMULATION ABROAD: Today the yield on the 10-year bond is driven by many factors, but there are really only a few select factors that actually matter. The first is the absence of any safe yields above zero or even equal to zero throughout the rest of the world, within the developed markets, as central bankers, EXCEPT THE US CENTRAL BANK, continue to pump money into their debt markets to flood investors with liquidity, bringing demand for bond yields way up and yields way down. Meanwhile, the U.S. Fed is a net liquidity taker, at the same time when the country is running twin deficits. This leads inevitably to higher rates and it has, but prices of bonds in Japan, Europe, and other developed markets drive traders over to the U.S., where prices are low and yields are substantial. Should that change, the traders move where the money flows.

EURODOLLAR LIQUIDITY & THE SHAPE OF THE YIELD CURVE

I can't emphasize how important building a throughout understanding of the actual dynamics, actually how the money moves, etc. in the Eurodollar markets. For those who don't know yet (don't feel back, you would be shocked at how few do), a Eurodollar is simply a U.S. dollar sitting in a bank outside the U.S. Companies in Ireland who do business shipping widgets to Asian companies must use dollars to import all of the intermediate supplies used to build the widgets and once they're made, the company receives HKD or EUR depending who they're sold to. The world has a huge problem with the dollar as the reserve currency, as there simply is not enough dollars to support all of the debts that have accumulated throughout the international money markets. Certain countries are short dollars needed to fund key imports to fund the working capital of the economy. This is having a profound impact on international money flows and thus also impacts the level of the USD and demand for Treasuries.

RATE DIFFERENTIALS and THE CARRY TRADE Currently, the spread on 2-year government yields in the U.S. relative to the the German Schatz (2-year yields) is over three percent. Meanwhile, you have to PAY TO LEND TO THE GERMAN GOVERNMENT FOR TWO YEARS - negative interest rates mean lending to the German government costs you half a percent. If instead you're a trader, you sell German Schatz and collect that 0.5% while receiving euro from the borrowings in German-denominated debt. Quickly, you convert the euro to US dollars, and invest them into U.S. Treasuries paying you 3 percent +. Add to that the 50bps on the German sales and the carry trade is well and alive.

THE YIELD CURVE: DO LONG-RATES REACT TO FED HIKES? The 10-year also reflects the "smart money's" outlook for economic growth over the long-run. As we recently saw, Fed Powell was resolute with regard to his planned hike strategy while the balance sheet simultaneously rolls off the balance sheet (which translates to a major YoY swing from liquidity suppliers to liquidity takers. Simultaneously, U.S. deficits and debts are skyrocketing. As of late, the narrative has been so prevalent around "synchronized reflationary global growth," despite the fact that central banks across the globe still inject masses of liquidity into their financial markets in an increasingly ineffective attempt to drive inflation. The long-end of the yield curve, i.e. the 10-year Treasury yields, and in particular their reaction to hikes by the Fed at the short-end of the curve, reveals a lot about the true views about longer-run economic growth among those investing in bond markets. Those left trading in bond markets are typically Institutional and have significant experience - few would argue they don't know what they're doing.

If you look at the charts, one might wonder given the insanely high correlations among these survey figures and actual data which piece of the puzzle is wagging, the tail wagging the dog? Looks like it increasingly so. Demand for 10-year Treasury bonds is driven by factors ranging from a flight to safety, attractive real returns ("real rates"), especially facing the slight, but still possible prospects, of the geopolitical situation continuing to escalate into something quite dangerous that would have the ability to bring down almost all economies. unstable and economically fragile global environment return by borrowing in European debt at a negative rate (in other words, getting paid to borrow euro, which is bemusing due to its relative resilience when the US is paying 300 basis points positive interest while the Germans may negative 50 (negative half a percent on the 2-year Schatz), and on the German 10-year bunds, they pay >3 percent less than US Treasuries. Would it not, then, be logical to borrow debt in EUR while getting paid half a percent for doing so,and then take these euros you've borrowed, exchange them for dollars and buy US Treasuries? convert this money plus interest into USD to invest in Treasuries that pay over three percent, keep investing in euro bank accounts where negative interest rates will cause an auto-5% decline (just an exaggeration, the negative percentage isn't that bad just yet but ANY NEGATIVE INTEREST should be considered outright atrocious. The Chairman of the Chicago Fed made a statement a couple weeks ago in a speech that he simply couldn't figure out what was going on any longer.

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The two instruments are separated by funding objective, time and quite possibly inter-galactic forces.

Fed funds is the deposit rate payable to commercial banks for overnight deposits at various Fed Reserve Banks throughout the US. The FOMC meet to set this rate, depending on their success in adhering to governance framework around stable employment, growth and inflation targets.

Ten year note yields are the borrowing cost - over that horizon - of the US government at any point in time, based on a semi-annual coupon accrual.

The spread between the two represents the market's expectations for all of growth, inflation, credit migration and default costs and many other flow and relative value factors against other, global ten year debt instruments.

Can it be measured? Yes, as yield/rates difference spread. Is it meaningful? Yes, as an indication of curve steepness, which represents the economy's position in the credit cycle amongst other things.

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