In the previous article we learned that spot (current) interest rates allow us to derive the market’s expectations of rates in the future.

COOL!

Let’s explore how that works, and then see what the current rates are telling us about where the market’s headed!

When we chart interest rates of a similar product for various maturities, we get what’s called a yield curve.

It is simply the rate a borrower would pay (or lender would earn) for loans of different maturities.

This yield curve comes in many shapes, such as the following.

And from the curves above we can actually derive the market’s pricing of the spot rate in the future.

To do so, we need to accept what is known as Expectations Theory.

As a simple example, let’s say we know the 2-year spot rate and the 1-year spot rate. A lender has a choice here. He can lend his money for two years, or he can lend his money for 1 year and then reinvest his principal + interest for another year.

Market arbitrage ensures that the lender ends up with the same amount no matter which of these he chooses.

And that means that we can solve for the missing red section to get the 1-year spot rate 1 year in the future! Or at least what the market is betting the rate will be.

This is called a forward rate.

Right now the yield curve is enduring one of the longest lasting inversions in history.

Remember that an inverted curve means that lending for longer periods pays less than lending for shorter terms.

Here’s the current US Treasuries Yield Curve:

We can see that the 3-month yield is roughly 5.5% and the 10-year yield is about 4.2%. Remember: in “normal” times, the 10-year yield is higher than the 3-month yield. Not so today.

Exercise for the reader: Given that the 6-month yield in the above chart is about 5.2%, can you calculate what the market expects the 3-month yield to be three months from now? In other words, can you calculate the 3-month forward rate three months into the future?

[Answer at end of newsletter…]

Historically, inverted yield curves almost always precede recessions. Why might this be?

Well, among many complicated theories, the simplest one is that an inverted curve means the market expects future interest rates to be lower than today.

This potentially signals a coming slowdown in economic growth, with investors believing that lending short-term is riskier than long-term.

Knowing this, and considering the growing correlation between Tradfi and crypto, what is a crypto degen to do?

Wait until we have a recession and then go long, hoping for a 50x? Or assume that all this boomer TradFi stuff won’t bleed into DeFi?

Next week we’ll explore patterns in the business cycle in a bit more depth before moving on to look at interest rate signals in DeFi.

From the information that the 3-month yield is 5.5% and the 6-month yield is 5.2%, we can infer an additional piece of information: the market’s expectation for yield from the beginning of month 4 to the end of month 6. In other words, we can infer what the 3-month Treasury will yield three months from today.

If we were to deposit $100 into a 3-month Treasury today, we would have $100 + ($5.5 x 3/12) upon maturity in three months, or $101.38.

If we were to deposit $100 into a 6-month Treasury today, we would have $100 + ($5.2 x 6/12) upon maturity in six months, or $102.60.

That implies that—based on today’s market expectations—that if someone deposited $101.38 in Treasuries during the three-month span between months four and six, they would receive $102.60 back. The annualized yield can be calculated as ($102.6/$101.38 - 1) x 12/3, or 4.05%. In other words, the 3-month forward rate three months from today is 4.05%.

The astute observer will note that the 3-month forward rate three months from today is lower than than 3-month spot (current) rate. The market expects the 3-month Treasury to yield less in the future. What is the significance of this?

Treasuries are typically the baseline rate for all other rates in the economy. Since lending money to the US government is among the safest things one can do to generate a yield, all other loans are can be thought of as Treasury rate + x. So Treasury rates are a general proxy for all other interest rates such corporate loans, mortgages, auto financing, and more.

That's all for today! Subscribe to our Substack to get these hot off the press.

Let me know what you think or would like to see in the future. Next week we'll take a look at some macro cycles and crypto positioning.

And a big thanks to our sponsor, Size Lending, a DeFi marketplace for fixed rate loans for any maturity.

In the previous article we learned that spot (current) interest rates allow us to derive the market’s expectations of rates in the future.

COOL!

Let’s explore how that works, and then see what the current rates are telling us about where the market’s headed!

When we chart interest rates of a similar product for various maturities, we get what’s called a yield curve.

It is simply the rate a borrower would pay (or lender would earn) for loans of different maturities.

This yield curve comes in many shapes, such as the following.

And from the curves above we can actually derive the market’s pricing of the spot rate in the future.

To do so, we need to accept what is known as Expectations Theory.

As a simple example, let’s say we know the 2-year spot rate and the 1-year spot rate. A lender has a choice here. He can lend his money for two years, or he can lend his money for 1 year and then reinvest his principal + interest for another year.

Market arbitrage ensures that the lender ends up with the same amount no matter which of these he chooses.

And that means that we can solve for the missing red section to get the 1-year spot rate 1 year in the future! Or at least what the market is betting the rate will be.

This is called a forward rate.

Right now the yield curve is enduring one of the longest lasting inversions in history.

Remember that an inverted curve means that lending for longer periods pays less than lending for shorter terms.

Here’s the current US Treasuries Yield Curve:

We can see that the 3-month yield is roughly 5.5% and the 10-year yield is about 4.2%. Remember: in “normal” times, the 10-year yield is higher than the 3-month yield. Not so today.

Exercise for the reader: Given that the 6-month yield in the above chart is about 5.2%, can you calculate what the market expects the 3-month yield to be three months from now? In other words, can you calculate the 3-month forward rate three months into the future?

[Answer at end of newsletter…]

Historically, inverted yield curves almost always precede recessions. Why might this be?

Well, among many complicated theories, the simplest one is that an inverted curve means the market expects future interest rates to be lower than today.

This potentially signals a coming slowdown in economic growth, with investors believing that lending short-term is riskier than long-term.

Knowing this, and considering the growing correlation between Tradfi and crypto, what is a crypto degen to do?

Wait until we have a recession and then go long, hoping for a 50x? Or assume that all this boomer TradFi stuff won’t bleed into DeFi?

Next week we’ll explore patterns in the business cycle in a bit more depth before moving on to look at interest rate signals in DeFi.

From the information that the 3-month yield is 5.5% and the 6-month yield is 5.2%, we can infer an additional piece of information: the market’s expectation for yield from the beginning of month 4 to the end of month 6. In other words, we can infer what the 3-month Treasury will yield three months from today.

If we were to deposit $100 into a 3-month Treasury today, we would have $100 + ($5.5 x 3/12) upon maturity in three months, or $101.38.

If we were to deposit $100 into a 6-month Treasury today, we would have $100 + ($5.2 x 6/12) upon maturity in six months, or $102.60.

That implies that—based on today’s market expectations—that if someone deposited $101.38 in Treasuries during the three-month span between months four and six, they would receive $102.60 back. The annualized yield can be calculated as ($102.6/$101.38 - 1) x 12/3, or 4.05%. In other words, the 3-month forward rate three months from today is 4.05%.

The astute observer will note that the 3-month forward rate three months from today is lower than than 3-month spot (current) rate. The market expects the 3-month Treasury to yield less in the future. What is the significance of this?

Treasuries are typically the baseline rate for all other rates in the economy. Since lending money to the US government is among the safest things one can do to generate a yield, all other loans are can be thought of as Treasury rate + x. So Treasury rates are a general proxy for all other interest rates such corporate loans, mortgages, auto financing, and more.

That's all for today! Subscribe to our Substack to get these hot off the press.

Let me know what you think or would like to see in the future. Next week we'll take a look at some macro cycles and crypto positioning.

And a big thanks to our sponsor, Size Lending, a DeFi marketplace for fixed rate loans for any maturity.