Why Futures-Implied Rates Can Fall During Fed Tapering
Summary
The discussion addresses why a yield curve built from three-month Eurodollar futures can shift downward even while the Federal Reserve is reducing asset purchases. Its central point is that futures-implied rates do not represent expectations of future policy rates alone. A rate also reflects a term premium for bearing duration risk and a convexity adjustment, so a declining curve may reflect changes in these components as well as lower rate expectations.
The answer also identifies a change in estimates of the neutral interest rate as relevant to longer-dated forward pricing. The question supplies a sequence of futures-derived rates across years and compares two sampling dates, but the response does not quantify how much of the observed movement comes from expectations, term premium, or convexity. The explanation is therefore a framework for interpreting the curve rather than a decomposition of the specific observations. It cautions against inferring the effect of tapering directly from the direction of futures-implied rates.
Key ideas
- Eurodollar futures rates combine expected rates with term premium and convexity effects.
- A downward move in implied rates need not mean expectations alone have fallen.
- Term premium can change as compensation for duration risk changes.
- The estimated neutral rate can influence pricing of longer-dated forwards.
- The supplied curve observations are not decomposed into their individual drivers.
Tags
Full text
# Why interest rate future does not support fed policy on reducing assets buying?
# Why interest rate future does not support fed policy on reducing assets buying?
Using the 3-mon eurodollar interest rate futures, I construct a yield curve each year for 2015-2021 using sampling date from the end of the month. If you graphed this out, you would see that the curve is shifted down each year. What I guess that is saying is that as time goes on, the market expectation for the interest rates is declining. That assessment is quite the contrary to the fed policy's tapering of asset purchase. If the fed is reducing buying assets, the rate should go up, but why would the market expectation on interest rate go down?
```
1/2/14 1/31/14
2015 0.6274% 0.5574%
2016 1.5723% 1.4198%
2017 2.7359% 2.4620%
2018 3.6504% 3.2965%
2019 4.2711% 3.8773%
2020 4.6554% 4.2679%
2021 4.8879% 4.5192%
```
## Answer by Helin (score 2)
https://quant.stackexchange.com/a/14877
There are quite a few reasons:
- Fed funds futures rate and Eurodollar futures rate do not reflect market expectations alone. Technically speaking, a risk-free interest rate is the sum of 1) rate expectations, 2) term premium, and 3) convexity bias. Term premium is typically positive, since investors demand a higher yield for taking on more duration risk (i.e., because a 10-year bond is riskier than a 1-year bond, even if rate expectations are constant, you might expect the 10-year bond to have a higher yield). So when interest rate goes down, it could be rate expectations are coming down, or perhaps term premium is coming off, or both. The best writing on this subject (from a practitioner's perspective) is Antii Ilmanen's "Understanding the Yield Curve." I myself have written a few articles on this topic. For example, you may look at Bond Risk Premium (Part II) – Clash of Two Theories and Bond Risk Premium (Part IV) – Decomposing the Yield Curve.
- The "Neutral Rate": Even the Fed's projection of the neutral level of interest rate has declined. At the beginning of the year, the Fed's famous dot chart had a median neutral rate of 4%, but it has since come down to 3.75%. This has a lot of implications for pricing long-dated forwards.Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.