Interest Rate Markets: A Practical Approach to Fixed Income

Chapter 6

Understanding Drivers of Interest Rates

So far we have considered the mechanics of interest rate products such as Treasuries and swaps. Once we understand the mechanics of interest rates products, we can use them to take views on interest rates across maturities and markets. This chapter considers the thought process behind forming views on interest rates that can be implemented using the rate products discussed. Before we consider where interest rates may be headed, we must clarify what is meant by the term “interest rates.” Instead of any particular maturity, we will consider the entire yield curve when trying to understand interest rate movements. By forming views on the yield curve, we consider both the level of rates and the shape of the curve as related concepts. Yield curve trades can be initiated in any fixed income market, such as swaps or Agency debt, but the starting point is to consider Treasuries as the baseline risk-free rate. Other rates can be considered as the combination of a Treasury rate and an additional spread to the Treasury rate. For example:

The second part of the equation—5-year swap yield – 5-year Treasury yield—is referred to as a swap spread and can be thought of as an asset of its own with separate drivers. A view on fixed income markets other than Treasuries can then be formulated as the base Treasury interest rate view as well as the incremental ...