Tuesday, January 26, 2010

Here's how much rates are expected to rise

A question from a reader made me think that this chart might be of interest. It comes from Bloomberg, and is designed to show the market's implied forecast of interest rates at different points in time. The current Treasury yield curve is the bottom red line, and as you move up the chart you have the expected curve 1, 2, and 5 years from now.

The mathematics of the yield curve dictate that if you want to make money by shorting a bond today, then you will win your bet only if the yield on that bond exceeds the expected yield. Thus, you can make money shorting the 10-year for the next 5 years only if the 10-year yields more than 4.9% at the end of that period.

It's also interesting to see just how much the market expects the Fed to tighten over the next 5 years: by some 450 bps. This is like the "line" in betting: you win the bet on rising interest rates only if they exceed the line.


jj said...

Interesting chart, wondering where these values are determined, futures mkts, cash forward mkts, swaps??
Thx, J

Scott Grannis said...

These values are all determined by the mathematics of the yield curve. Given any current yield curve, the forward yield curve can be calculated using nothing but the current values.

You start by assuming that investors are rational. If they accept a lower overnight yield than they could get from a 2-year yield, it is because they expect the overnight yield to rise. For example, the current fed funds rate is 0.25%, and the 2-year Treasury yield is 0.8%. That means that the fed funds rate must be expected to average 0.8% over the next year, otherwise investors would not accept the current yields. So obviously the fed funds rate will have to be greater than 0.8% two years from now. Pure math, nothing fancy.

Unknown said...

Thank you - for your post and answer. I am thinking that if we expected inflation to be higher - -then there is also a reasonable probability that rates too will be higher than expected - -and shorting the bonds could be a good bet.