Wednesday, May 20, 2009
Forward Thinking On U.S. Interest Rates
The table above, printed from Bloomberg, is a matrix of forward Treasury yields. Forward yields are derived from the shape of the yield curve and the shape reflects the market's expectation of what is to come by discounting what is known today. More specifically, it is where the market believes the Federal funds rate will be. This is especially true at the shorter maturities whose level and slope are almost entirely dependent on market expectations for what the Fed is going to do.
At present, for example, the two-year Treasury is yielding 83bp but it is priced to yield 1.75% in a year's time. From an investor's standpoint, assuming you are looking to park money in Treasurys for two years, you can buy the two-year at 83bp or you can buy the one-year and roll the money into a new one-year in one year's time. If you choose to buy the one-year at 42bp today and the one-year yield in one year's time is higher than 1.29% then you are better off buying the one-year and rolling at maturity. If the one-year is lower in a year's time, better off buying the two-year today.
In other words, if you want to make a buck bet against the curve one way or the other. And the curve today is assuming that the 0 to 25bp funds rate range will be over and funds will be trading at 1% in a year's time. I am not saying where the funds rate will be but it pays to know how the market is priced before deciding how to invest.