Interest Rate Forwards

Market Rate Forecasts

The indicator calculates a percentage probability of an RBA interest rate change based on the market determined prices in the ASX 30 Day Interbank Cash Rate Futures.

The zero coupon bond yield curve implied forwards are derived through bootstrapping, interpolation and smoothing the specific yields on individual Australian Government Bonds.

Generally the spot interest rates futures market is much more responsive and elastic to changes in market conditions than the bond market. This is due to the limited range of bond instruments and the smoothing applied through the Nelson Siegel interpolation.

Accuracy of Market Implied Rate Forecasts

The prediction interval illustrated above reflects the average of the deivation between market implied forward rates and the actual cash rate over the selected period. Over the full available sample, at a 12 month horizon the absolute deviation is typcially plus or minus 1 rate cut (ie 0.25 percent). The absolute deviation between the market implied forecast (f) and the actual cash rate (r) is calculated as:

Includes the P99th and P90th quantiles of the absolute error distribution.

Sources

• Cash Rate Futures: RBA Rate Tracker
• Zero coupon bond yield curve

Market expectations of an interest rate increase at the next RBA Board meeting

Source: RBA Rate Tracker Calculation

The expectation of a rate change by the RBA is calculated by taking into account the number of days the RBA Target Cash Rate is known versus the number of days in the month that it is unknown ie: the number of days before and after the RBA Board Meeting. By incorporating this time factor into a probability equation the following formula can be used to determine current market expectations on whether or not the RBA will change the Target Cash Rate:

Where:

• : probability of rate change
• : current yield on 30 Day Interbank Cash Rate Futures
• : current known Target Cash Rate less the differential between the Target Cash Rate and the Overnight Cash Rate
• : expected new Target Cash Rate less the differential between the Target Cash Rate and the Overnight Cash Rate
• : fraction of month where target rate is known (ie: before RBA official rate announcement), eg: 2/31 for December 2003
• : fraction of month where target rate is unknown (ie: after RBA official rate announcement), eg: 29/31 for December 2003, therefore .

As at there is a of a 25bp at the next RBA board meeting.

Solving for :

Note that for a rate rise: and for a rate cut: , therefore . In the following calculation, a positive 0.25 is used which implies:

• if : market implied probability of 25bp rate increase;
• if : market implied probability of 25bp rate decrease.

Comparative performance of forecasters

The following chart compares the probability of an interest rate increase (or decrease) at the next RBA Board meeting with the actual RBA decision each month. Two sources of forecasts are compared:

• the market implied probability derived above (the first forecast in the month before the RBA meeting);
• the average expectation of economists as reported by Finder.com.