Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Forward Rate Agreements
Transcript
- Lucas: Central banks spend a lot of time telling us where they think interest rates are going. But what if we could just... look at what the market itself expects, in real time, from actual traded contracts? Luna: You're talking about forward rate agreements. Specifically, the overnight indexed swap market. Lucas: Exactly. An Overnight Indexed Swap — OIS — is a contract where two parties exchange a fixed interest rate for the geometric average of an overnight reference rate over a set period. For the Bank of England, that reference rate is SONIA — the Sterling Overnight Index Average. For the ECB, it's the €STR. Luna: And the fixed leg of that swap essentially becomes the market's best guess of where the average overnight rate will be over that horizon. Which, for a central bank targeting an overnight rate, is a direct read on policy expectations. Lucas: Right. So if a central bank wants to know whether its forward guidance is credible, it can look at the 3-month OIS rate, say, and compare it to its own projected path. If there's a gap, someone's wrong — either the market or the central bank. Luna: And that gap matters because it feeds back into financial conditions. If the market expects rates to stay higher than the central bank says, long-term bond yields might already be pricing in that hawkish path, tightening conditions before the central bank even moves. Lucas: Let's make this concrete. Take the Bank of England in September 2023. The Monetary Policy Committee had raised Bank Rate to 5.25% and was guiding cautiously — hinting that rates might be near their peak. But if you looked at the 6-month SONIA OIS rate on September 20, 2023, it was pricing in a peak of around 5.5%. Luna: That's a 25 basis point gap. The market was effectively saying 'we don't fully believe you're done'. Lucas: And the Bank of England had a choice. It could either lean against that expectation by reinforcing its guidance — or let the market be right. In the event, they did hike once more in November, to 5.5%, which validated the ois implied path. Luna: So you could argue the OIS market was more accurate than the central bank's own communication at that moment. That's a powerful tool for listeners who want to understand where rates are actually heading — look at what the market is pricing, not just what officials say. Lucas: Exactly. And central banks themselves use this data internally. The Bank of England's Monetary Policy Committee receives a regular briefing called 'Market Implied Rates' which is basically a chart of OIS forward curves. It's one of the inputs they use to calibrate their own reaction function. Luna: The ECB does the same with €STR OIS. During the 2022 tightening cycle, the ECB was behind the curve initially — the OIS market was pricing in rate hikes months before the Governing Council actually delivered them. In fact, by mid-2022, the 1-year €STR OIS rate was already implying a terminal rate above 2%, while the ECB was still at -0.5%. Lucas: That's a massive disconnect. And it created a problem because the market was effectively doing the tightening for them — financial conditions were already tightening via higher swap rates, even though the policy rate was still negative. That's part of why the ECB eventually had to accelerate their pace. Luna: So OIS rates give you a high-frequency, forward-looking measure that's free of some of the noise you get in other market rates — like the term premium in government bonds. Lucas: That's the key advantage. In a government bond yield, you have the expected path of short rates plus a term premium — compensation for duration risk. In an OIS, the duration is usually short, and the credit risk is minimal because it's a swap collateralized by cash. So the OIS curve is a much cleaner read of pure policy expectations. Luna: But it's not perfect. The OIS market has less liquidity at longer tenors — beyond 2 years, the bid-ask spreads widen and the implied rates become less reliable. Also, during stress events, the OIS market can itself get distorted by counterparty risk premiums or funding constraints. Lucas: Right. In March 2020, at the peak of Covid market turmoil, the SONIA OIS market saw some dislocations because banks were hoarding cash and the unsecured lending market seized up. The overnight index swap is supposed to strip out credit risk, but in practice, the counterparty risk still matters when no one wants to trade. Luna: So central banks have to interpret OIS data with those caveats. But used carefully, it's one of the most direct windows into market expectations of monetary policy. Lucas: And it's not just for central banks. Any investor — whether you're buying bonds, managing a portfolio, or just trying to figure out if the mortgage rate will go up — can look at OIS forward curves to get a sense of where the market thinks policy is headed. You don't need a Ph.D. in finance. Just knowing what the 1-year OIS rate implies about the future policy rate is actionable information. Luna: It democratizes a bit of central bank insight. You're basically seeing the same data the MPC sees. Lucas: Exactly. And that brings us to something we hear a lot from listeners: how do they keep getting this kind of analysis without it being locked behind a paywall or stuffed with ads? Well, this show stays independent and ad-free thanks to listeners who support it. If walking through the economy with us has made something click — maybe today's episode gave you a new way to read the interest rate landscape — you can help keep it going by buying us a coffee. That's at buy me a coffee dot com slash fexingo. No pressure, but it makes a real difference. Luna: And it's a small way to say 'keep doing this.' Because honestly, having a show that digs into the mechanics without selling you something is rare. Lucas: Alright, back to the mechanics. One more thing worth noting: central banks don't just passively observe OIS rates; some of them actively use FRAs to implement policy. The Fed, for instance, uses OIS in its open market operations to signal the expected path of the federal funds rate. Luna: But the Fed has the federal funds futures market too — that's another way to extract expectations. How do those compare? Lucas: Federal funds futures are similar but based on the effective federal funds rate rather than an overnight index. The difference is subtle. OIS rates are typically a bit lower because they're tied to a broader, more secure rate like SOFR. But both give you essentially the same information: the market's expectation of where the central bank's policy rate will be. Luna: And for listeners who want to check this themselves, Bloomberg and Reuters have OIS forward curves. Even some free sites like FRED from the St. Louis Fed publish OIS data. Lucas: Right. So next time you hear a central banker say 'rates will stay low for a long time,' pull up the 1-year OIS rate and see if the market agrees. That gap — or lack of it — tells you more than the press conference often does. Luna: It's like having a real-time credibility check on the central bank's word. Lucas: And that, in a nutshell, is why forward rate agreements matter for monetary policy. They're not just obscure derivatives — they're the market's honest answer to the question 'where are rates really going?'