The bonds connection

It’s hard to write about this subject, but bonds is something that cannot be left out of the equation. i have been pondering for some time what part bonds play in interest rate movements. Does the bond yield lead or trail interest rates? Lets explore that.

For one thing, mortgages in the US are closely linked to bond yield, especially the 10-year Treasury Note. This article explains

Fixed mortgage rates typically track the yield on the 10-year treasury note. “The 30-year mortgage tends to have roughly the same [sensitivity to interest-rate changes] as a 10-year treasury,” says T.J. Marta, a fixed-income strategist at RBC Capital Markets. “On average, people pay off their mortgage roughly every 10 years.” The outlook for inflation plays a key role in determining the yield on the 10-year treasury, Marta says.

In order to compensate lenders and investors for the risk that home loans will not be repaid, mortgage interest rates are set higher than the yields on 10-year treasuries, which are essentially risk free. Historically, the typical difference between mortgage rates and the 10-year treasury yield””known as the spread””has been roughly 1½ percentage points. In the mortgage industry, the difference between these two rates is often referred to as a “risk premium.”

However, that is where the relation ends, as many will tell you (see also this article). Basically long term interest rates are not correlated with short term interest rates, so we can leave the 10 years and above bonds out of the picture. Instead, we want to look at how short term treasuries are related to fed funds rates.

Some googling around leads to this insightful forum thread comment – “The main influence on the T-bill yield is the anticipated FFR. It would be surprising if the T-bill yield did NOT lead FFR.  I would expect the market to have a better idea of what the Fed will do than the Fed itself. That said, the T-bill yield is not the best leading indicator of the FFR. A better leading indicator is the FFR futures rate. That is because there are other influences on the T-bill yield.” So the 3 months treasury bill yield and the Fed Funds Rate Futures are useful lead indicators of the Fed Funds Rate.

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