Wednesday, October 15, 2014

Forward Rates and the Business Cycle

Interest rates have taken a dive recently.  This has mostly been at the long end of the curve.  Here is a kind of messy graph of expected future changes in interest rates (assuming pure expectations) and realized changes in rates.  Forward rates appear to have been a fairly unbiased predictor of rate changes in normal times, but they have tended to overstate forward rates at the extremes.  While flat yield curves have predicted economic contractions, ensuing collapses in interest rates have been much more negative than predicted by the yield curve.

One question is, does the recent decline in rates foreshadow a coming contraction?  I would say, according to the first chart, no.  A fall in the long term yield slope is not unusual, even in the early stages of rising short term rates.

In the past few cycles, the recoveries ended with short term rates that rose higher than the yield curve had predicted, then collapsed.  The same pattern happened in the mid 1990's, but we avoided the recession in that episode.

Here is another view of recent rate movements.  This is from Eurodollar markets.  We can see here that expectations about rate increases in the near term have been very stable since the beginning on QE3.  The June 2016 contract has been relatively level since late 2012.  Both long rates and near term rates rose in the summer of 2013, which I consider to be evidence that those movements were a product of improved expectations, and were not related to tapering issues.  But, once, tapering began in late 2013, long term rates began a long decline.  The recent decline worries me, because we are seeing a correction in equities at the same time that we are seeing rates fall across the yield curve.

Here is another view of yield curve movements during the current year.  Here, again we can see that the character of rate increases in the 2015-2017 time frame has been fairly stable.  But long rates have been on a relentless, steady decline.  They are almost down to the ridiculously low level I had expected of them, though I didn't originally expect it this quickly.  I had been positioning for a strong economy this year that would push rates up more quickly than the yield curve predicted.  In effect, I was ready for that bump in rates that we saw at the end of recoveries in the first graph.  But, I have become worried about credit markets in the near term because real estate credit hasn't seemed to have picked up its own steam in the face of the end of QE3.  So, I think we could have a catastrophic period ahead if rates continue to collapse and the Fed delays further accommodation.  It is possible that real estate credit regains momentum and my original yield curve forecast still could hit the mark.  It is also possible, I think, for the economy to have enough strength outside real estate to help us muddle through for a while, in which case rates and inflation might remain low for a couple more years, followed by a delayed rebound in rates.

Here is one more chart, which compares the 3 month rate with the (5,2) forward rate (the rate from,  roughly, year 5 to year 7).  Here we can see the yield curve recession indicator.  The three recessions in this period happened after the short rate hit the same level as the forward rate.  But, I think this graph is interesting, because we can see that in 1984 and 1994 the Fed raised short rates up to the level of the forward rate.  The reason forward rates remained above the short rate was because the forward rate rose along with short rates, and the Fed stopped raising short term rates when the forward rates started to decline again.  But, in 1988, 2000, and 2006, the Fed kept raising the short term rate even as forward rates were falling or remaining level with the short rate.

The worst case scenario is that the forward rate keeps falling even without any short term rate increases.  That was happening before QE3 helped boost forward rates.  The forward rate has a smoother trend than constant maturity treasury rates, because it doesn't include the volatile short part of the yield curve.  (I have bootstrapped treasury rates to estimate the forward rates.)  If forward rates fall back to 2012 levels of below, that will probably be a bad sign.  If they don't, then the interaction of the short term rate with the forward rate might be something interesting to watch.


  1. Excellent and thoughtful blogging. My only contribution is that this time is different due to global gluts of capital, and perhaps other deflationary influences in the economy.

    This means that monetary policy should be bullish an expansionary, and that quantitative easing should become a permanent part of a central bank toolkit.

  2. Great point, Benjamin. I'd prefer to see them push inflation expectations high enough that QE goes away, though, but that might not be politically feasible.

    BTW, I think you'll like today's post. The Atlanta Fed has a great bunch of data on LFP, including some data on disability.