Using the Yield Curve to Forecast Interest Rates

8/2/2019 Using the Yield Curve to Forecast Interest Rates

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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-100-

basis-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.


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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 forsix-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 [email protected], and I will

try to help.
mailto:[email protected]:[email protected]:[email protected]:[email protected]

Using the Yield Curve to Forecast Interest Rates

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