The impact of demand and liquidity on the informaton content and predictive power of the government bond yield curve: An illustration from the UK gilt market

Abstract

Investment analysis that analyses both the current condition and future direction of the market must make use of key macroeconomic indicators such as the current and (market-expected) future level of interest rates. Fund managers in the capital markets frequently use the government bond yield curve as part of this analysis. The use of the government bond term structure to determine the market's expectation of future interest rates is well established. This reflects the fact that the current (spot) yield curve is the geometric average of the same maturity structure implied forward rates. The predictive power of the spot curve is illustrated here using examples from the past, in conjunction with the money market swap yield curve. Low levels of liquidity resulting from an excess of demand over supply in government bonds may reduce the predictive power of the term structure, or render its information content inaccurate, owing to an artificially generated shape of the yield curve. The example used here to illustrate this suggests that, in these cases, the swap yield curve could be used to determine market expectations of future interest rates. It is concluded that the swap curve is currently the only viable alternative instrument in the sterling debt markets, but its use is not necessarily entirely satisfactory.