Using the Yield Curve to Forecast Interest Rates

Roy Hingston, senior vice president and chief balance sheet strategist, Shay Financial Services All of us need to create an annual operating budget. In order to produce that report, we need to forecast net interest income, interest income, and interest expense. In order to do that, we must have an interest rate forecast to use for the model. How do we produce such an interest rate forecast? We could keep interest rates unchanged all year, or we could use one of the rate-shock forecasts, such as up-100basis-points. The problem with the rate-shock scenarios is that they are simply not real-world. Rates do not change instantaneously, nor do they move in a parallel fashion, and they most certainly do not stay in one place after they change. What we need is something that looks more like the real world. In the real world, rates change over time, short rates move more than long rates, and they keep changing throughout the plans timeframe. Most of us try to develop a most likely interest rate scenario that we create after talking to economists or other experts. There is another alternative, and perhaps a better one at that. We can make use of the yield curve to create our forecast. In fact, the yield curve has proven itself to be one of the best predictors of future interest rates. The yield curve also depicts what we describe as the term structure of interest rates. In testimony last year before the Senate Banking Committee, Chairman of the Federal Reserve Alan Greenspan made the following comment: The simple mathematics of the yield curve governs the relationship between short and long-term rates. Ten-year yields, for example, can be thought of as an average of 10 consecutive one-year forward rates. To the extend a Fed chairman is starting to talk about forward rates, we all need to become more familiar with the concept, both in theory and in the way it is used in the real world. The Theory is Quite Simple Let's say that as an investor, you have the choice of investing for two years at, a hypothetical rate of 4.00%, or investing for one year at 3.00% and then making another investment for the second year. What rate would you need to receive in the second year to make up for only getting 3.00% in year one instead of the 4.00% you could have received? The two-year investment pays 4.00% in year one and 4.00% in year two, for a total of 8.00% over two years. In order to make up for receiving only 3.00% in year one, you would have to earn 5.00% in year two to come up with a total of 8.00% over two years. The Implications Are Important Using this example, the theoretical implication of this choice, is that in one year, the one-year rate will rise from the current level of 3.00% to a new level of 5.00%. Therefore, the market is implying that short-term rates will rise by 200 basis points over the next 12 months. By the same token, if we take todays three-year rate (times 3) minus todays one-year rate, we will be able to calculate the two-year rate one year from now. If the three-year rate was, say 5.00%, we would earn 5.00% in year one, year two, and year three for a total of 15% overall. From that number, we subtract the one-year rate of 3.00%. That means we would need to earn 12% total from the two-year note we buy one year from now, or 6.00% each year. Therefore, the two-year note, one year from now, is expected to be 6.00%, up from todays two-year note of 4.00%. This again would imply that rates are expected to rise by 200 basis points over the next year.

We could continue this process for all remaining maturities on the curve. We would take the current one-year rate from the four-year rate to determine the three-year rate one year from now. We would take the one-year rate from the five-year rate to find out the four-year rate one year from now, and so on. In this way, we could create the entire yield curve that the market is predicting will exist one year from now. The Real World The real world no longer uses the Treasury curve to predict forward rates. The markets use the swaps curve. The markets use this curve because it is more directly related to other market forces than the Treasury curve, which can become disconnected to other market rates when Treasuries become scarce due to supply issues or due to large foreign central bank buying. The swap curve is created by mapping the rate corresponding to each time period that the fixed-rate payer of an interest-rate-swap contract would pay. The floating rate payer always pays the same short-term rate (equal to threemonth LIBOR). For example, under the terms of a five-year interest rate swap, one party will pay the floating rate and the other party will pay the fixed rate. In todays market (as of March 15, 2006) that rate would be 5.18%. By comparison, the fiveyear Treasury rate was 4.69%. The swap curve will normally be higher than the Treasury curve since it represents a rate closer to a borrowing rate than an investing rate. The actual swap rates for March 15, 2006, are shown in the table below. The Forward Curve If we take the two-year swap rate of 5.15% (times 2) and subtract the one-year swap rate of 5.16%, we calculate that the one-year rate, one year forward, will theoretically be 5.14%. The actual rate will be slightly different due to the exact calculation of the present value of all future cash flows discounted back to present value at different rates. The computer calculates the actual rate to be 5.111%. If we take the three-year rate of 5.14% (times 3) and subtract the one-year rate of 5.16%, we calculate the two-year rate, one year from now, as 5.15%. (((4.20%*3)-(3.78))/2) (The computer calculates the exact number as 5.133%). If we continue with this methodology, we create the forward yield curve shown in the table below.

Swap Curve 3/15/06

Forward Curve 3/15/07

Change

1 Year

5.16%

5.111%

-5 basis points

2 Year

5.15%

5.133%

-2 bp

3 Year

5.14%

5.160%

2bp

4 Year

5.16%

5.180%

3bp

5 Year

5.18%

5.208%

3bp

7 Year

5.22%

5.252%

3bp

10 Year

5.27%

5.293%

2bp

15 Year

5.32%

5.342%

2bp

20 Year

5.34%

5.358%

2bp

30 Year

5.34%

The Implications The conclusion is that, as of March 15, 2006, the current swap curve is implying that short-term interest rates will decline by about five basis points over the next 12 months. (We subtracted todays one-year rate from next years one-year rate to calculate this number). In todays flat environment, the intermediate and long-term sectors are expected to rise by no more than two to three basis points over the next year. In addition to being able to create a forward yield curve that can be implied one year forward, we could create one for six-months from now. The methodology is the same. That curve tells us that the one-year rate will be 5.19% six months from now. This means that we can use this type of knowledge to create an interest rate scenario on which to base the annual budget. We can forecast that short-term rates will rise from 5.16% today to 5.17% in six months and decline to 5.11% by the end of the one-year period. I hope this helps to take some of the mystery out of this subject. If not, email me at rhingston@shay.com, and I will try to help.