The financial media is catching wind that interest rates are going to be increasing. Although I believe the Bank of Canada is fairly firm in holding their overnight rate at 0.25% until the end of June, the question remains how much they will raise rates in July. I thought that it was going to be an evolutionary 0.25% increase over the next scheduled meetings of the central bank, but there might be a larger jump.
Futures markets are signaling the following compared to the same time last month (January 2009):
| Month / Strike | Bid Price | Ask Price | Settl. Price | Net Change | Vol. |
| + 10 MR 0.000 | 99.545 | 99.550 | 99.550 | -0.005 | 4412 |
| + 10 AL 0.000 | 0.000 | 0.000 | 99.510 | 0.000 | 0 |
| + 10 MA 0.000 | 0.000 | 0.000 | 99.460 | 0.000 | 0 |
| + 10 JN 0.000 | 99.400 | 99.410 | 99.410 | 0.000 | 16860 |
| + 10 SE 0.000 | 99.030 | 99.040 | 99.030 | 0.000 | 19502 |
| + 10 DE 0.000 | 98.630 | 98.640 | 98.630 | 0.000 | 17457 |
| + 11 MR 0.000 | 98.240 | 98.250 | 98.250 | 0.000 | 2335 |
| + 11 JN 0.000 | 97.900 | 97.920 | 97.910 | 0.000 | 1360 |
| + 11 SE 0.000 | 97.550 | 97.620 | 97.600 | -0.010 | 175 |
| + 11 DE 0.000 | 0.000 | 97.350 | 97.300 | -0.050 | 56 |
| + 12 MR 0.000 | 97.000 | 97.090 | 97.050 | 0.000 | 0 |
| + 12 JN 0.000 | 96.740 | 96.870 | 96.810 | -0.040 | 7 |
| + 12 SE 0.000 | 96.530 | 96.670 | 96.600 | -0.030 | 7 |
| + 12 DE 0.000 | 96.320 | 96.500 | 96.370 | 0.030 | 7 |
We can see the projected interest rate for December 2010 is 1.36%, while December 2011 is around 2.7%.
Another metric to look at is long term bond rates – 5-year bond rates (which determine how expensive 5-year fixed rate mortgages will be) are currently trading at 2.56%, but this has not changed too much over the past half year. If the markets were anticipating significant amounts of inflation, they would most likely hit the longer term bond markets first.
The expectation theory states that long term rates are a representation of the short term rates that will existing throughout the maturity of the debt. As such, the markets are expecting an average of 2.56% over the next five years – since rates for the next 5 months will be at 0.25%, it hints there will be a period of time where we will see short term rates at or around 3%. Interest rate futures say this will be around March and June of 2012.
My financial crystal ball suggests that the markets are pricing this in correctly.
Since the yield spread (between the 10 year and 2 year bond) is around 2.1%, it does suggest that there will be some sort of economic recovery – my sense in terms of how to play this is to load up on commodities until the yield curve flattens. When the yield curve flattens, the party is over.