Monitoring interest rate fluctuations, spreads and the yield curve requires careful review of current economic conditions, policies, and market movement. It is not a simple task by any means, but it involves nearly every touch point at the bank and must be carefully reviewed. Knowing your exposure to interest rate risks will help in recognizing signals that imply changes in rates. In doing so, you will find your bank managing, stabilizing and hopefully improving net interest margin.
There are three reference points to start your search for interest rate signals: The Federal Reserve, the Department of the Treasury, and the Chicago Board of Trade (CBOT).
The Federal Reserve
The Federal Reserve is an obvious place to look for policy changes. The Federal Open Market Committee (FOMC) commonly comments on the rate situation, as they utilize the federal funds to manage economic growth, short-term borrowings for banks, and interest rates. They most recently established a variety of programs that stabilized and lowered long-term rates on mortgages through guarantees.
During the most recent FOMC meeting, Fed officials kept the Fed funds target rate at the current level. There was one dissenter (and has been for the last three meetings) who wanted to change language being cited by the FOMC. According to the press release, Thomas M. Hoenig “believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted.”
Department of the Treasury
The Department of the Treasury would be the place to pull data for the treasury yield curve, but stepping away from bond pricing, we have a more fiscal relationship. The Treasury is in charge of the national budget and our debt. Out-of-control debt can lead to out-of-control inflation. Generally speaking, high levels of debt can degrade confidence in a country’s bond market and devalue currency, as the global market demands less of those bonds and currency. As demand falls for bonds, yields will begin to climb.
So, it appears that rates move on information; they fluctuate with new releases and commentaries. Whether it implies that the Fed committee members are beginning to shift sentiments, or the national debt is continuing to rapidly expand, interest rates are likely to react. We can see these reactions in the bond market; the changes are virtually seamless. Similarly, the futures market moves with the ebb and flow of the information, however, it reflects yield expectations.
Chicago Board of Trade
The futures market currently is anticipating a slow rise in overnight rates, at least within the U.S. Looking at the CBOT Fed Funds futures.
Short-term rates are expected to near 50bps this fall/winter. By summer/fall 2011, rates are expected to near 100bps for the Fed funds, while the London Interbank Offered Rate (LIBOR) is likely to be closer to 150bps.
LIBOR is derived from the Eurodollar futures based on the CBOT statement that:
The final settlement price of Eurodollar futures is determined by the three-month LIBOR on the last trading day. Bets on the longer-term treasuries are showing similar patterns, but not nearly as significant increases. This could indicate the yield curve becoming less steep and treasury short-term rate spreads may shrink. This is based off the premise that long-term investors are more sensitive to rate increases and face greater risk. Some investors manage this risk by selling "puts" on treasuries which is considered to be a way to hedge against this sort of interest rate risk.
These three reference points will surely help clear up some of the inconsistencies with regard to interest rate movements. They may help create expectations, providing your bank with a rough idea of your current risk exposure and even help maximize your margins.