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Gilts as a predictor of Future Interest Rates

You have talked about short Sterling here in the last week or two. I saw that Bates (a bank I think) in an article in the Sunday Times recently quoted the Gilt curve as the 'best indicator of future rates'. Estates Gazette lists data:

- projected 3 month LIBOR
- the swap curve

So that is four measures. But can you truly define what should be the best measure?

This was the question I received yesterday from Trevor. Since I thought this might be of interest to our readers I'm publishing the answer here:

A gilt is a UK government bond. When you buy it you pay for the right to receive a fixed coupon each year. This will be based on a notional percentage, so for example you may have a bond that has a 9% coupon for 10 years. If you buy £100 of this bond you will receive 9% of £100 each year, and of course your initial £100 pounds back at the end. What is this bond worth? Well you have to work out what each £9 coupon on the given dates is worth today since today is when you are buying the bond. Now, the lower interest rates are, the more those £9 chunks are worth today. Imagine if interest rates are 5% then being paid £9 in a year's time is worth today 9 / (1 + 5%) = £8.57. So if we can work out exactly what interest rates are going to be in each of the year gaps we can come up for a correct price for the bond. However no-one knows and hence bond prices move as the market re-aligns its guesses as to what each interest rate will be. As I've pointed out, if interest rates fall, bond prices go up as that fixed 9% interest becomes more attractive.

Now, the UK Government is a good quality issuer who is highly unlikely to default on its debt. Hence, you are willing to accept a lower yield (interest rate) when you lend them your money than you would from say a normal bank.. Now , the rates that normal banks lend money for 3 months at is LIBOR , an average calculated daily by ringing up 16 banks and finding out where they will lend you sterling (UK pounds) for 3 months.

So if you want to borrow money off a large bank (between banks), they will structure an interest rate swap. In doing this, they will quote you a fixed rate (like the 9% coupon) above that they will lend you money at for a fixed time, in exchange for payment each 3 months at the LIBOR rate. The reason they want to do this swap is that it replicates the change in price of a bond without having to swap the large initial payment. It's similar to doing a spread-bet as compared to buying a share.

Again, to calculate the price you need to make some guess as to future 3 month interest rates for each period.

As explained before the rate on a 10 year swap will be higher than that for a government bond because the credit risk is worse.

Now, how can I guess the course of future interest rates - well this is where short sterling futures comes in. Futures were invented as a homogenized, easily traded way to bet on future interest rates. As pointed out before they are contracts based on 3 month LIBOR on a given date - usually the third Wednesday of March, June, Sep and Dec.

These are represented as 100 - interest rate so for instance if Jun 03 is quoted as 95.50 then the market is telling us it expects 3 month LIBOR on third Wednesday June 2003 to be 4.5% (100-0.045 = 95.5).

These futures can be quoted for up to 10 years out and so with a bit of interpolation or the like we can make a good guess at where interest rates will be on any given day for up to 10 years and thus price bonds fairly accurately.

Just returning to the difference between the yield on a gilt and the 10 year swap, this difference will be known as the asset swap on will move according to how the market views risks in the world [for instance when the Asian crisis happened people got very nervous about banks going bust and so the demand for government bonds pushed the gap to a very high amount, say 100 basis points (1 %)].

As you can see the relationship between bonds, swap rates and futures is ever changing, and if one gets too far out of line, arbitrageurs will quickly move in to erase that anomaly (particularly in swaps versus futures as a swap is really just a series of futures on different dates to the usual convention).

So, what does this tell us about house prices? Well, SVR's are usually quoted as some point above LIBOR e.g. 75 basis points over LIBOR.

Now, with swaps, it is fairly easy to find out what interest rate they are implying for 5 years time. So If you can find out what 3 year interest rates are implied to be in 5 years time (say 5.2%).

Then I would return to today, find out today's three year swap rate and today's standard three year mortgage rate. Find out the gap between the two.

Now add this gap back on to the 3 year interest rate in 5 years time and you have the 3 year mortgage rate in 5 years time.

So should we use gilt rates at all? I would hesitate to as there are a lot of supply and demand issues in gilts that you don't have with swaps. Swaps are trickier to play with however but who said it would ever be easy? ;-)

So are the financial futures markets reliable predictors of the future?

The short answer is no. I have seen plenty of graphs mapping implied interest rates against what actually happened and there are big differences. As in any market, for example government bonds, the futures tend to over exaggerate what happens in any direction. They don't really replicate the "jumpiness" of real interest rates, they tend to show a far smoother curve. It is the unpredictability of the magnitude of the rate moves that can catch the futures out, if there is a 50% chance of a half a % move and a 50% chance of a quarter point move, the future will show a 0.375% move as the most likely course.

All we can really say is that low interest rates don't tend to go on for ever, or do high interest rates - their very function is to bring the inflation rate back to around 2.5% and so if you add on a fudge factor based on 4% real inflation gap you should say that in the long term interest rates will probably be around 5-6%. So if interest rates go down to 2% borrow a lot for a long time. If interest rates go up to 15% buy government bonds.

Apart from that the minute movements are almost impossible to predict. You'll just go mad trying. It would be great to have a predictor of future interest rates that was easy to understand or calculate and I bet a few people in the City wish the same ...8-).