Christopher J. Neely

English

Research Papers in Economics

October 2003
MonetaryTrends
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
Bond Market Mania
A
s the figure’s top panel shows, U.S. 10-year
Treasury note (bond) yields have been very
volatile since May. Yields fell more than 75 basis
points from May 1 to their nadir June 13, before soaring—
more than 125 basis points—after the FOMC’s June 25
statement. Many financial analysts blame the Fed’s
announcements for this disorder. For example, the FOMC
announcement of May 6 was widely interpreted to herald
sustained lower short-term rates and/or the purchase of
long-term bonds by the Fed to effect “easier” monetary
policy: “...the probability of an unwelcome substantial fall
in inflation, though minor, exceeds that of a pickup in infla-
tion from its already low level.” In contrast, the financial
press interpreted a less-than-expected federal funds target cut
and an almost identical press release following the June 25
FOMC meeting to mean that the Fed was reversing course
by playing down the possibility of a fall in inflation.
How might the Fed’s announcements have influenced
bond yields? There are two major components to current
U.S. Treasury yields: expected inflation and a real com-
ponent. Higher expected inflation raises interest rates
because lenders demand compensation for the expected
loss of purchasing power. But the real rate depends on the
expected productivity of physical capital. A robust economy
and high productivity encourage businesses to borrow to
finance future production, bidding up interest rates.
Did the Fed’s statements influence bond yields by
changing expectations of inflation, real activity, or both?
Although we cannot directly observe the components of
long-term interest rates, we can estimate real interest rates
from the yields on Treasury inflation-indexed securities
(TIIS). The principal and coupon payments on TIIS are
indexed to the CPI to protect investors from inflation.
Thus, the usual interpretation is that projected inflation is
reflected in ordinary bond yields but has no effect on TIIS
yields, and the market’s forecast of inflation is approxi-
mately the difference between these yields. Complicating
this calculation, however, is the fact that deflation does not
reduce TIIS principal payments; a higher probability of
deflation will reduce TIIS yields. The probability of
cumulative deflation over a ten-year period must be low,
so TIIS yields probably still mostly reflect real returns.  
The first two panels of the figure show that from May
through July, U.S. real interest rates (10-year TIIS yields)
moved almost as much as 10-year nominal yields. Unless
expectations of cumulative deflation changed dramatically,
forecasts of real growth drove most of the fluctuations in
Treasury yields. This conclusion challenges the interpreta-
tion that Fed statements caused the bond market volatility
by changing inflation expectations. 
The figure also shows that nominal and real yields in
the United Kingdom followed much the same pattern as
that in the United States, which bolsters the interpretation
that changes in forecasts of real returns—rather than greater
expectations of deflation—drove the fluctuations in U.S.
bond yields. Trade and financial markets link economic
activity and real interest rates in the U.S. and the U.K. 
The bottom panel shows expected inflation as the differ-
ence between nominal yields and inflation-indexed yields
for the U.S. and the U.K. As the first two panels imply,
expected U.S. inflation fell much less than the U.S. real rate,
slipping only about 20 basis points from April to mid-June,
before rising again. Expected inflation in the U.K. showed
no trend over this period, however, probably due to the
Bank of England’s explicit 2.5 percent inflation target.
—Christopher J. Neely
Available on the web at research.stlouisfed.org
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
3.0
2.5
2.0
Mar Apr May Jun Jul Aug
Mar Apr May Jun Jul Aug
Mar Apr May Jun Jul Aug
Nominal Yields
Inflation-Indexed Yields
Expected Inflation
U.S. 10-Year Bond Yield
U.K. 10-Year Bond Yield
U.S. 10-Year Inflation-Indexed Yield
U.K. 10-Year Inflation-Indexed Yield
U.S. Inflation Expectations
U.K. Inflation Expectations
1.5
SOURCE: Data are from Bloomberg and the Board of 
Governors of the Federal Reserve System.

Bond market mania

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Bond market mania

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