Term-Structure Factor Shifts and Economic News

For this article, daily changes in pure discount yields on U.S. risk-free securities were fit to a theoretically robust term-structure model to derive a set of orthogonal factors measuring the level, slope, and curvature of the yield curve. Changes in these factors at the release of unexpected economic news are reported. This methodology explicitly allows for commonalities in responses in the universe of spot rates, thus painting a rich picture of interest rate reactions to new information. The results have important implications for hedging volatility risk or seeking to profit from predicting volatility in bond prices. The argument that efficient markets respond quickly and completely to new information has been a cornerstone of empirical financial research for decades. Given the depth, breadth, and liquidity of the market for U.S. Treasury debt, Treasury yields react to the release of unexpected macroeconomic news in regularly scheduled announcements. Our research shows that reactions occur in a systematic way across the term structure and that an understanding of this phenomenon can enhance portfolio management strategies that are designed to hedge or profit from this predictable volatility.We studied adjustments in a set of orthogonal factors that represent shifts in the level, slope, and curvature of the term structure. The factors were estimated from daily zero-coupon yield changes and allowed for commonalities in responses across the universe of spot rates. Announcements for the following economic series were incorporated: the U.S. Consumer Price Index and Producer Price Index, nonfarm payroll, unemployment, retail sales, durable goods orders, housing starts, and industrial production. The generality of the analysis is important because it distinguished announcements that move the entire term structure in a parallel fashion from those that have incremental effects in the short range. Of the eight releases studied, the four that had the strongest systematic impact were announcements made at the beginning of each month—nonfarm payroll, industrial production, producer prices, and retail sales. Surprises in these four had a consistent, measurable impact on the term structure of zero-coupon yields that was felt equally across the entire maturity spectrum in most interest rate environments. Some announcements—most notably, nonfarm payroll—had incremental effects on the slope component as well as the level component.The underlying data were drawn from Treasury yields for 1982–2002—a long series that contains regimes of rising, falling, and neutral interest rates. This segmentation allowed us to discover that the responses to some surprises (specifically, nonfarm payroll and retail sales) occur later in the maturity structure in a falling-interest-rate environment than in a rising or neutral environment. Furthermore, in periods when the level of Treasury yields was adjusting to a new short-term equilibrium, we found that the market was sensitive to more types of announcements and that reactions to some announcements (notably, retail sales and housing starts) were significantly more pronounced.Taken as a whole, our findings indicate that traders believe increased demand from the producer sector initiates economic expansions, with a corresponding increase in the level of interest rates, whereas developments in the consumer sector sustain yield rallies. In addition, we suggest that announcement risk should be a systematic component of multifactor bond-pricing models and that it should be incorporated into trading strategies that seek to hedge against or profit from daily volatility in U.S. Treasury markets.