7.8 The signicance of term structure theories

rates. Then, if nominal interest rates are made up of a stable real interest rate and

expected ination, forecasts of future nominal interest rates effectively become fore-

casts of ination and, if we assume that markets are efcient and expectations are

correct, these must in turn be telling us about the current tightness or laxity of

monetary policy. That is, a sharply upward sloping yield curve becomes translated

into a forecast of sharply rising ination and a judgement that current monetary

policy is too loose. However, this use of the term structure has been subjected to a

great deal of testing which has not, in general, been favourable. Its apparent failure

has led to a good deal of criticism of the pure expectations approach to explaining

the term structure and considerable emphasis on the importance of term premiums.

In Box 7.6 we see how easily nancial markets can be taken by surprise and how the

yield curve can be changed by unexpected monetary policy decisions.

Box 7.6Monetary policy decisions and the yield curve

We have seen in Box 7.1 that in February 2003, the Monetary Policy Committee of the

Bank of England surprised nancial markets by cutting the Bank’s repo rate from 4 per

cent to 3.75 per cent. According to theory, nancial markets look well ahead and take

into account information about the future prospects of the economy. Thus, nancial

market prices should provide a good guide to future events. It follows that nancial

markets should be good at anticipating what the MPC is likely to do at its monthly meet-

ings and asset prices should change before the MPC meetings to reect any changes in

interest rates made in these meetings. This, in turn, should mean that asset prices should

not change much immediately after the meeting.

In February 2003, however, the markets had it wrong. The result was that gilt prices

(together with equity prices and the value of sterling) fell sharply when the MPC decision

was announced. Yields on short-dated gilts fell at the short end of the yield curve (the

part of the yield curve most sensitive to interest rate expectations) by up to 20 basis

points (0.2 per cent). Two-year yields hit a record low of around 3.35 per cent. The yield

curve steepened signicantly since yields for ten-year maturity fell only 2 basis points

(0.02 per cent) to 4.212 per cent. Gilt futures also rose, with June short-sterling contracts

recording a record high of 96.57, implying an interest rate of 3.43 per cent.

According to the Financial Times, analysts said that ‘the monetary policy committee’s

decision had dramatically altered the market’s perception of MPC’s stance. “It electried

the short sterling market – we saw an enormous jump,” said Don Smith, bond economist

at ICAP. “The interest rate prole priced in has shifted down almost by 25bp for the next

18 months. We pretty much have another cut priced in by June.”’*

This episode shows us:

(a)	the strength of the impact of monetary policy decisions on interest rates throughoutthe economy;

(b)	the extent to which central bank decisions affect short interest rates more than long rates and thus have an impact on the yield curve;

(c)	the importance of expectations in nancial markets.

* P Munter, J Wiggins and B Jopson, ‘UK interest rate cut surprises gilt traders’, FT.com website,

6 February 2003. FT

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Chapter 7 • Interest rates