Report

The short end of the forward convergence curve and asymmetric cat's tail convergence

Abstract: How is the term structure able to predict future interest rates several months in the future and why is it so steep at the short end? Recent empirical work shows that rates of mean reversion are too slow to help predict short rates or to account for the curve's steepness. We propose that short term interest rates are predictable because Federal Reserve actions are predictable. In particular, our estimates suggest that the market anticipates the Fed's monetary stance twelve months in advance. Moreover, forward rates contain more information when the Fed is expected to tighten than when it is expected to ease. When the market anticipates a tightening, expectations about rising short rates drive movements in near term forward rates. When the market anticipates an easing, the term premia drives movements in forward curves. This asymmetry in the behavior of forward rates with regard to future monetary policy stance explains the forward curve's typically humped shape. We argue that a rapid convergence to a Fed target when a tightening is anticipated but not when an easing is anticipated generates an average forward curve that is steep at the short end.

Keywords: Monetary policy - United States; Forecasting; Interest rates;

Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Research Paper

Publication Date: 1995

Number: 9523