Analysts warned to be wary of the yield-curve

Market participants that use short-term movements in the yield curve as signals of future economic development could be mistaken in their analysis, according to a recent report published by the Federal Reserve Bank of New York.

The authors of the study, John Kambhu and Patricia Mosser, argue that the development of interest rate options in the late 1990s has changed the short-term dynamics of the yield curve. The ability to hedge interest rate exposure created by interest rate option tools has enabled options dealers to adjust hedging positions they have taken to offset options exposure. The authors argue this “feedback” effect causes such trades to affect market liquidity, and can ultimately push interest rates further in the direction they were moving.

Kambhu and Mosser argue that such “feedback” effects can alter the shape of the curve, and warned against making assumptions based on a short-term change in the yield curve. The report, “The Effect of Interest Rate Options Hedging on Term-Structure Dynamics”, stated: “The times when market participants and policymakers are most interested in extracting from the yield curve a signal about economic fundamentals are precisely the times when changes in the curve may be distorted by liquidity effects.”

The report concluded that analysts should caution against interpreting short-run movements in the yield curve as signals of future economic development.

A copy of the full report is available at www.newyorkfed.org