Longer-term Interest Rates #primers

While the Fed determines short-term rates, longer-term interest rates are determined by the market. The Fed can however try to influence longer-dated Treasury yields by buying longer-dated bonds.

A common framework for thinking about longer-term yields is to think of them in two parts: the expectations for the path of short-term interest rates, and a term premium. For example, you would expect the returns you could earn on a 10-year Treasury bond to be at least equal to lending risk-free overnight to the Fed for 10 years. But you'd also expect extra money (a term premium) for keeping your money locked up for 10 years (or however long it takes to mature; the longer the term, the higher the term premium).

The first part depends on how the market perceives the Fed to act in the future, which in turn depends on how the market perceives future inflation. Fortunately, there is an easy way to see what the market thinks the future path of policy will be.

The short-term interest-rate futures market offers a glimpse of what the market thinks short-term interest rates will be in the future. The most popular short-term interest-rate future is the market for Eurodollar futures. The Eurodollar futures market is one of the deepest and most liquid derivatives markets in the world. Eurodollar futures are essentially the market’s best guess of what future 3-month LIBOR rates will be. Since 3-month rates are firmly within the Fed’s control, this is largely a bet as to what the Fed will do in the future, which in turn is a bet based on how economic conditions will unfold, made by the largest and most capable market participants in the world.

#primers