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

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  • Joseph Dziwura
  • Irene Pedraza
  • Eli M. Remolona

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.

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  • Joseph Dziwura & Irene Pedraza & Eli M. Remolona, 1995. "The short end of the forward convergence curve and asymmetric cat's tail convergence," Research Paper 9523, Federal Reserve Bank of New York.
    • Handle: RePEc:fip:fednrp:9523
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    References listed on IDEAS

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    Cited by:

    1. Fangxiong Gong, 1995. "Regime-switching monetary policy and real business cycle fluctuations," Research Paper 9528, Federal Reserve Bank of New York.
    2. Aggarwal, Raj & Schirm, David C., 1998. "Asymmetric impact of trade balance news on asset prices," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 8(1), pages 83-100, January.
    3. Marshall, Andrew & Musayev, Taleh & Pinto, Helena & Tang, Leilei, 2012. "Impact of news announcements on the foreign exchange implied volatility," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 22(4), pages 719-737.
    4. Joseph Dziwura & Eric M. Green, 1996. "Interest rate expectations and the shape of the yield curve," Research Paper 9631, Federal Reserve Bank of New York.

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