Short-term rate expectations and markets

In keeping with the principle that the golden age is never the present one, we should disabuse ourselves of the notion that investing ever had a golden age of fundamental analysis. Once central bankers turned themselves into central planners, a condition prevalent since the inflationary 1970s, financial markets have been giant guessing games as to their next moves. The financial crisis of 2008-2009 and the response by multiple central banks to push short-term interest rates toward zero and to flood their banking systems and monetize their national debts with printed money, a campaign known as quantitative easing, raised the expectations game to a new and celestial level.

This phenomenon has reached a new and perverse level with negative sovereign debt yields, competitive currency devaluations and the fracturing of currency pegs such as the Swiss franc ceiling against the euro. You really have to wonder whether modern central bankers might think if taking two aspirin is good for a headache then taking 20 must be better.

What was ironic in all of these efforts is central banks claimed to use these market measures to assess how their policies were being received; that they were reading the effects of their own actions often seemed lost upon them. Traders learned how to use federal funds futures to measure expected changes in the effective federal funds rate, but that tool was neutered unceremoniously after the December 2008 adoption of a zero interest rate policy (ZIRP). The forward curve of Eurodollar futures retained some value but was plagued by both its links to LIBOR and to its de facto anchoring at the very short end by monetary policies. 

The Treasury yield curve itself was distorted at both ends by both ZIRP and, after August 2011, by deliberate attempts to suppress long-term interest rates in “Operation Twist.” The Federal Reserve dominated the market for both conventional and inflation-protected securities all through the quantitative easing era and then they studied the spread they themselves had created for clues on inflationary expectations.  

Central bankers had to stare at the “mirror, mirror on the wall” and ask who was the fairest banker of them all. Moreover, markets had no choice but to price in the desired outcome of all these interventions. After all, sitting down to a poker game with someone who brings a deck full of aces and a printing press is a dicey venture.

All of this makes a quantitative measure for reading a market’s expectations increasingly valuable.  

Swaptions to the rescue

Let’s stipulate no interest rate market has been able to remain free of these distortions, including the two-year interest rate swaps discussed in this article. These swap rates often are priced and hedged with Eurodollar futures and therefore are subject to artificially low rates for these “white” and “red” contracts produced by deliberately accommodative monetary policies. The implied yield of these Eurodollar strips is the fixed leg of the swap; receiving the fixed-rate is a long or lending position in the two-year segment and paying the fixed-rate is a short or borrowing position. If someone is borrowing at a floating-rate and fears higher interest rates (a bearish outlook) they might want to fix their payments by paying a premium, the swap spread, to do so. This could be accomplished either in the cash market or by taking a short position in the futures market. A rising swap spread indicates rising bearishness or fear of rising interest rates.

However, just as in the case of all markets supporting options, the pattern of volatility changes often is a more sensitive indicator of relative anxiety. So it is with interest rate swaps. The volatility of an option to enter into the fixed leg of a swap rises as traders buy insurance against rising rates. These swaptions, a clever portmanteau if there ever was one, are a pure and relatively low-cost bet on directional interest rate risk and therefore can be used as a measure of interest rate expectations.

Wall Street’s financial engineers have created different forward-starting dates, functionally equivalent to an option’s expiration and exercise date for these swaptions along with a different set of tenors, or length of time during which the swap will be operative. Let’s focus on at-the-money, three-month forward-start swaptions with two-year tenors to match this most expectational segment of the yield curve.

Post-QE history

If we map two-year swap rates against the swaption volatilities since the March 2009 launch of QE1, we see a remarkable confluence of behavior (see “Who’s following whom?” below). In a classic case of “now-casting,” as rates rise or fall, so do swaption volatilities. The swaption volatility may appear to lead the swap rate itself, and this certainly would make for a nice story if it did, but neither market leads the other statistically. What we can say is lower yields bred complacency during this period and higher yields bred fear. This is pro-cyclical behavior or herding at its worst; the best time to buy an umbrella is on a sunny day, not a rainy one, but the swap market is enamored of the principle of lending low and borrowing high.

While the swaption market chases swap rates around dutifully, it manages to ignore the hiccups in the swap yield curve as measured by the forward rate ratio between two- and ten-year swaps (FRR2,10). This is the forward rate between two- and 10-year swaps divided by the 10-year swap rate itself; the more the ratio exceeds 1.00, the steeper the yield curve. 

As the post-QE1 yield curve has been anchored at the short end, nearly all of the variance in the FRR2,10 has been caused by movements in 10-year swap yields. While the era has witnessed a few flattenings or declines in the FRR2,10, the picture generally has been one of a steeper yield curve and declining swaption volatilities. 

The large jump in the FRR2,10 in October 2014 represented a sudden decline in two-year Treasury rates as the market began to unwind expectations of a mid-2015 increase in short-term interest rates. The market discovered the error of its ways and pushed the FRR2,10 down sharply into January 2015.

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About the Author

Howard L. Simons is president of Rosewood Trading. @simonsresearch