The short end and monetary policy distortions

The dynamics of short maturity money market yields is more complex and idiosyncratic
than that of longer maturity bond yields. We have already seen a hint of this
in Figure 5.6(c), which shows that including T-bill yields in the dataset radically
changes the results of a principal component analysis; the third eigenvector represents,
not a ‘curvature shift’ affecting 3–5 year maturities, but a ‘hump shift’ affecting
maturities around 1 year. This is confirmed by more careful studies.
As with curvature shifts, hump shifts might be caused by changes in the term
premium. But there is also an economic explanation for this kind of yield curve shift:
it is based on the observation that market expectations about the path of interest
rates in the near future can be much more complex than longer term expectations.

For example, market participants may believe that monetary policy is ‘too tight’
and can make detailed forecasts about when it may be eased. Near-term expected
future interest rates will not assume the simple form predicted by the macroeconomic
model of Figure 5.4 if investors believe that monetary policy is ‘out of equilibrium’.
This kind of bias in expectations can create a hump or bowl at the short end of the
yield curve, and is illustrated schematically in Figure 5A.1.
One would not expect a ‘hump factor’ to take a stable form, since the precise form
of expectations, and hence of changes in expectations, will depend both on how
monetary policy is currently being run and on specific circumstances. Thus, one
should not feed money market yields to a principal component analysis and expect
it to derive a reliable ‘hump shift’ for use in risk management.
For further discussion and analysis, see Phoa (1998a,b). The overall conclusion is
that when managing interest rate risk at the short end of the yield curve, measures
of parallel and slope risk must be supplemented by more detailed exposure measures.
Similarly, reliable hedging strategies cannot be based simply on matching parallel
and slope risk, but must make use of a wider range of instruments such as a whole
strip of Eurodollar futures contracts.