Friday, November 22, 2013

Speculation about movements in 2013 Interest Rate Futures

Interest rates have made several broad moves through 2013.  Here is a graph of Eurodollar futures at four turning points during the year:

The following graph is of deconstructed versions of the Eurodollar forward rates, reflecting the expected date of the first short term rate increase and the rate of the increases that follow.

May 1 was roughly the low point in forward rate expectations.  At that point, the first rate increase was expected at the end of 2015, with a slope of only about 20bp per quarter after that.  I have speculated that this low slope was actually a reflection of inflation uncertainty.  Market expectations of a steeper slope might have been tempered by uncertainty about the Fed's balance sheet, which could have lowered bond yields across the yield curve.

From May 1 to June 14, unexpected improvements in the economy caused the expected date of the first rate increase to move forward, but Fed uncertainty kept the subsequent slope fairly flat.

In June, the Fed clarified its intentions for ending QE3 and eventually planning rate increases.  Bernanke announced an intention to continue pushing rates down.  Rates went up immediately, which was widely attributed to expected tightening, but I believe that the main cause was a reduction in the probability of outlier outcomes in the Fed's balance sheet management, which caused the slope of the yield curve to more accurately reflect market expectations.(1) (2)  As the August 1 snapshot demonstrates, in the weeks following the announcement, the expected date of the first rate increase did not move, but the slope of the yield curve increased.

Since then, we have had the government shutdown and the Obamacare debacle.  In the meantime, economic news has still been fairly stable, and Janet Yellen has become the presumed replacement for Ben Bernanke.  Most observers expect Yellen to be more aggressive with monetary stimulus, which is taken to mean, among other things, that she will wait longer before raising rates.  In addition, there are whispers of the Fed moving its unemployment rate threshold target for raising rates from 6.5% to 6.0%.  That brings us to the current curve (Nov. 20 in the graph), where the rate rise has moved back to the end of 2015, but the slope is now over 30bp per quarter, which reflects a market very confident about a typical interest rate recovery coming out of the zero lower bound.

This gets complicated, because the Fed's stated policy stance and the effect of its stance on interest rates are self-contradictory in their nature.  If the market really does expect the Fed to be more accommodative and to delay a reversal of its Open Market Operations (OMO), then the subsequent boost in economic activity should actually push inflation and real economic growth up, so that the rate increase actually happens sooner.

So, the current expected rate increase seems to be a conservative, naïve (by which I mean unbiased) reflection of the Fed's implied policy stance.  I think both inflation and unemployment are more likely to skew this to a sooner date than to a later date, but I don't think we can expect the slope of the yield curve to get much steeper than this.  So, I think we are still looking at rates in the 2016-2017 time frame coming in roughly in the range they have been dancing around for the past few months, with the current rates being the bottom of the range.

Here is a graph of the slope of the Treasuries yield curve over the past 30 years or so.  The slope is understated at the current time because the zero lower bound makes the slope in the unadjusted treasury curve slightly less steep than pure expectations would normally make at the short end of the curve:

The blue line is the difference between the 1 year treasury rate and the implied 2nd year rate from bootstrapping 1 and 2 year treasuries.  The shadow columns are the actual changes in the forward 1 year rate compared to the immediate 1 year rate.  There are several items of note:

1) Coming out of an interest rate collapse, it is very common for the yield curve slope to top out at about 50bp per quarter, or slightly less.  I think this more or less caps the top end of forward rates that one would need to be prepared for.

2) Well-known research has shown that an inverted or flat yield curve is a very reliable predictor of coming recessions.  But, as reliable as it has been, the 1-2 year forward yield curve has massively underestimated the level of rate reductions that have happened during those recessions.

3) Even outside recessions, the forward yield curve has overstated the actual rise in rates.  During this time, the yield curve overestimated the actual rise in rates in the 1 to 2 year time period by an average of more than 1%!  I realize that there is some maturity premium, but not 1%  within the first 2 years.  On the one hand, I am currently arguing for a short position in forward bonds, so this worries me.  On the other hand, this is at least partly a reaction to the volatile inflation of the 1970's, and may eventually disappear or reverse, especially since interest rates don't really have anywhere to go but up or sideways.

4) The bond market sure looks like it wanted a more aggressive Fed.  Coming out of 2009 in the midst of QE1, forward rates were ready for a standard rate recovery.  Then the Fed cut QE off, and forward rates died.  They picked up again with QE2, and then died again as it also was cut off too early.  They are picking up again.  I hope the natural recovery strength of the economy and the new expectations from Janet Yellen will pull us the rest of the way out as we exit QE3.


  1. Hope this positive update keeps up and we'll see rise in employment next year.

  2. Think of the interest rate as the price of capital, one of the three fundamental resources the other two being labor and land, where land includes natural resources.
    What effect would raising the price of a fundamental resource be? There's your answer.