The changing information content of market interest rates

Most central banks rely on a variety of information sources in forming their outlook for the economy and, accordingly, assessing the stance of monetary policy. Important among those sources are quotes on financial market instruments, because they are critical links in the monetary policy transmission mechanism, because they embed expectations about the future course of monetary policy and the economy, and because they are available on a realtime basis. However, many different factors potentially influence the prices of financial instruments, including movements in risk-free interest rates, perceptions about the risks of various assets and changes in the value that investors place on liquidity. Thus, extracting information from those prices can be difficult. This paper attempts to provide some insight into the behaviour of key long-term interest rates in the United States since 1993 by parsing their movements into those of more fundamental underlying factors. In particular, the analysis decomposes the variations in five key market rates into factors representing the risk-free interest rate, liquidity preference and credit risk, as well as idiosyncratic shocks to the Treasury and swap markets. Concentrating on these underlying factors, rather than the market interest rates themselves, brings financial market developments over that period into sharper focus. The results indicate that the importance of individual factors has shifted in recent years, with significant consequences for the information content of market interest rates and, presumably, the appropriate investment and hedging strategies of private investors. Among other findings, it appears that Treasury yields have varied more as a result of shocks specific to that market in recent years, and that corporate yield spreads have increasingly been affected by factors other than credit risk.