Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Overnight Index Swaps to Read Markets
Transcript
- Lucas: If you want to know what the market thinks the Federal Reserve is going to do with interest rates, you do not look at the fed funds rate itself. That is a policy target, set by the FOMC. You look at something called the overnight index swap rate, or OIS. Luna: OIS. I first encountered that term reading about the plumbing of the repo market back in 2019. It kept showing up in Fed speeches. Lucas: Right. And it is one of those instruments that sounds technical but is actually elegant. An overnight index swap is essentially a contract where two parties agree to exchange a fixed rate of interest for a floating rate that tracks a published overnight benchmark. In the US, that benchmark is the effective federal funds rate — or more recently, the Secured Overnight Financing Rate, SOFR. The fixed leg of the swap is the OIS rate. Luna: So if I pay the fixed OIS rate and receive the floating overnight rate over, say, three months, what am I actually doing? Lucas: You are hedging or speculating on the average level of short-term rates over that period. But more importantly for central bank watchers, the OIS rate strips out credit risk. Unlike a regular swap between two banks, where one party might worry about the other defaulting, an OIS is structured so that the principal is never exchanged — only the net interest difference. That makes it almost purely a reflection of expected policy rates. Luna: So when analysts say 'the market is pricing in a quarter-point cut,' they are usually reading that from the OIS curve. Lucas: Exactly. Take the FOMC meeting that just wrapped in June 2026. Ahead of the decision, the one-month OIS rate was trading at 4.32 percent, while the effective fed funds rate was 4.38. That six-basis-point gap told you the market saw a roughly 75 percent probability of a quarter-point cut. Not a guarantee, but a strong signal. Luna: And the actual decision was a cut. So the OIS was right. Lucas: It was. But that is not always the case. OIS reflects expectations, not certainty. And in times of stress, the spread between OIS and the actual policy rate can widen for reasons that have nothing to do with the policy outlook. March 2020 is the classic example. At the peak of the COVID panic, the one-month OIS rate briefly traded more than 75 basis points below the fed funds rate. That was not the market pricing in a massive emergency cut — it was a liquidity premium. Banks were hoarding cash, and the OIS market, which normally has very low counterparty risk, suddenly had a bit of funding friction. Luna: So the OIS can signal not just rate expectations but also stress in the short-term funding market. That is a dual use. Lucas: Precisely. Central banks watch OIS spreads the way an emergency room watches a patient's blood pressure. A sudden spike in the spread can indicate that banks are unwilling to lend to each other, even overnight. That is why the Fed publishes its own ois based measures of monetary policy expectations in its quarterly monetary policy report. They call it the 'ois implied federal funds rate path.' Luna: And then there is SOFR. You mentioned it earlier. SOFR is the underlying floating rate for most USD OIS now. That transition from fed funds to SOFR happened after the LIBOR scandal and the reforms of the last decade. Lucas: Right. Since 2022, the dominant USD OIS contract references SOFR rather than the effective fed funds rate. SOFR is a much broader measure — it covers overnight Treasury repo transactions, which run well over a trillion dollars a day. That makes it harder to manipulate. But the logic is the same: the fixed leg of a sofr based OIS gives you the market's expectation of average SOFR over the swap's term. Luna: So for practical purposes, when you hear 'the OIS curve is inverted,' it means the market expects rates to be lower in the future than they are today. Lucas: Yes. And the shape of that curve — not just the level — tells you something about the economic outlook. A steeply inverted OIS curve often precedes a recession, because it implies that the central bank will be cutting rates aggressively. That was the case in late 2023. Conversely, a positively sloped OIS curve suggests the market expects tightening or at least stability. Luna: I remember reading about the 'OIS discounting' controversy back in the early 2010s. That was a big accounting shift in how derivatives were valued. Lucas: Great point. Before the financial crisis, banks discounted derivative cash flows using libor based curves. But after it became clear that LIBOR included a bank credit risk premium, regulators pushed for OIS discounting. Why? Because OIS is considered the closest proxy for the risk-free rate. So now, by regulation, most cleared swaps use OIS as the discounting curve. That change alone reshaped how trillions of dollars in derivatives are priced. Luna: That is a profound shift. So OIS is not just a forecasting tool — it is baked into the infrastructure of the financial system. Lucas: It is. And that is why central bankers obsess over it. When the Swiss National Bank or the Bank of England wants to see if their policy communication is landing, they look at the ois implied rate path for their own currency. If the OIS curve moves in line with their guidance, the transmission mechanism is working. If it diverges, they have a problem. Luna: And there is a specific number from this year. In April 2026, the two-year OIS rate in the UK was about 25 basis points below the Bank Rate, suggesting the market expected two cuts within twelve months. The Bank of England then cut in May. Lucas: Right, that is exactly the kind of signal policymakers watch. Now, one nuance — OIS is not perfect. It can be distorted by technical factors like quarter-end balance sheet constraints or by shifts in the supply of Treasury collateral. But for a clean read on rate expectations, it is the best tool we have. Luna: So if I am a listener who wants to check the market's view of the next Fed meeting, where would I find the OIS rate? Lucas: Bloomberg, Reuters, or even the Fed's own website publishes the OIS curve. But a simpler way: the one-month OIS rate is often quoted in financial news around FOMC dates. Just remember that a change of a few basis points can represent a meaningful shift in probability. A 10-basis-point move in the one-month OIS is roughly equivalent to a 40 percent change in the odds of a quarter-point move. Luna: That is a handy rule of thumb. So next time I see 'OIS pricing in a 65 percent chance of a hold,' I know it is based on this instrument. Lucas: Exactly. And speaking of understanding the economy better — this is the kind of topic that we love to break down here. No ads, no sponsors. We keep these shows going because listeners like you find them useful. If you want to support that choice, the link is buy me a coffee dot com slash fexingo. Even a small contribution helps us stay independent and ad-free. Luna: Yeah, it really does. We don't have a big network behind us. It is just us and our listeners. So if this podcast has made something click for you, that link is there. Lucas: Alright. Back to OIS. One more wrinkle: the swap spread. That is the difference between a plain vanilla interest rate swap rate and the OIS rate of the same maturity. In normal times, it is a few basis points. But when it blows out, it signals that banks perceive higher credit risk or funding stress. In 2008, the two-year swap spread went from around 30 basis points to over 150. Luna: So OIS itself is a benchmark, and the spread between OIS and other rates is a diagnostic. Lucas: Exactly. Central banks use both. So if you want to sound like a monetary policy wonk, pay attention to the OIS curve. It is the closest thing to a market-based transcript of what the central bank is expected to do. And in a world where central banks rely heavily on communication, that transcript is gold.