The Treasury Bill Futures Market andMarket Expectations of Interest Rates*

ALBERT E. BURGER, RICHARD W. LANG, and ROBERT H. RASCHE

ECONOMISTS and other analysts seek to measureexpectations of future interest rates because such ex-pectations have important effects on economic behav-ior, Changes in expectations can lead to changes ineconomic activity, both at the level of the individualfirm or consumer, and at the level of the nationaleconomy. For example, interest rate expectationsenter into investment decisions of firms, porffolio de-cisions of financial intermediaries and other investors,and borrowing decisions of state and local govern-ments. If these groups alter their expectations of thefuture level of interest rates, changes in investment,portfolio, and borrowing decisions will occur whichaffect not only each group individually, but whichalso affect the level of economic activity in the econ-omy as a whole. Consequently, policymakers andresearchers have been interested in measuring marketexpectations of interest rates — first, to understandthe behavior of economic units in individual markets,and second, to monitor changes in expectations whichresult from policy actions, in order to judge the im-pact which the policy may have on the economy.

For example, consider the discussion surroundingthe recently aborted Federal income tax rebate. Theargument for such a policy was that it would stimu-late consumer spending, and thus stimulate aggre-gate output and employment. However, there wasconsiderable concern that the policy would cause anupward revision of short-term interest rate expecta-tions if there were general agreement that the Treas-urv would have to increase its borrowing substantiallyduring the second half of 1977 to finance the in-creased deficit. Under such circumstances, much, ifnot all, of the alleged stimulus that would be pro-vided by the tax rebate could be offset by the negativeimpact of higher interest rate expectations on firms’decisions to invest in real capital. Such a negativeeffect arises because the higher the expected level offuture interest rates, the less profitable the incomestream associated with each particular investmentproject. The examination of such effects of policy

~The authors gratefully acknowledge the assistance of Ms.Jeanne Rickey and the Statistical Department of the ChicagoMercantile Exchange for providing data used iu this paper.

actions would he made much easier if market expec-tations of future interest rates were readily observable.

A considerable amount of economic research hasbeen devoted to formulating measures of market ex-pectations of interest rates, since data on expectationsare not directly observable unless survey methods areused. Efforts at measurement have taken the form ofeverything from “informed judgement” to elaborateeconometric models. Another means of obtaining anestimate of the level of short-tenn interest rates ex-pected to prevail at some future date has becomeavailable since early 1976. This method employs theyield quotations of the futures market in U.S. Treas-ury bills. These quotations, which are available on adaily basis, embody market expectations of futureshort-term interest rates. This paper focuses on theinformation about market expectations which canbe obtained from yields on Treasury bill futurescontracts.

THE ROLE OF THETREASURY BILL FUTURES MARKETThe futures market in three-month U.S. Treasury

bills was opened on the International Monetary Mar-ket of the Chicago Mercantile Exchange in January1976, soon after the opening of a mortgage futuresmarket on the Chicago Board of Trade in October1975.’ Both of these futures markets in financial in-struments operate in essentially the same way as thetraditional commodity futures markets. Futures trad-ing in financial instruments allows the separation ofthe risk of unexpected interest rate movements fromother types of risk. Futures contracts can he used tohedge against interest rate movements in order toprotect actual or expected cash positions of marketparticipants. Profits are thereby protected in muchthe same way as hedging in commodity futures mar-kets protects against price fluctuations of a particularcommodity. Speculation is facilitated by the existenceof futures markets, which allow the assumption of

‘For details on the Treasury bill futures market, see the ac-companying section: “Characteristics of the Treasury BillFutures Market.”

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FEDERAL RESERVE BANK OF ST. LOUIS JUNE 1977

Characteristics oF 11w ‘I”r.’asurv Iii II llutures MarketThe Treasun bill futures market l,eg.in at Liv’ lead- iieasur~ bills mat Iii fig -it tile c,,,1 f tin cc’ inni,tl,s

ing or, jaiiiian Ii. I 9Th, ii. vl,r,tr,ll t~ ,i tI, ninth tin- third ~‘eek ml him’ 1978: -

tthirtee,,-week-; 1 S iic-.ismin bills lir- de1i’cr~ _\lt~ou&ithe si/V i-I a ‘logic’ initrut C is SI nn]I~’en.\Iarc Ii. June. St-’pteinht-r. amid Dc-c c’rnhc-r. Ougeim.dl’ .1 pen, hitt’re,teti ill hi,’ ilig ill selling a t ‘introit cull

there wele c,’l~four -c,ri&-ac-t~ truicini. the lLti’~t being ti (tIe iii this hitirt-s iit.irkc-t iii macgin. T]u- mthiinomer thus ~‘i’s c-nh i liii’ 5 ear in the ,1 itmu C - 8i it ii, j oh n iitial nuuit tmii I is ‘i I -StIll P

111 emil ru liii! hi- (-‘lIljjiljs-

1976 tue ininiber ill c’untr.u-ls \‘a’ Inc-n-awL1

to six. tlit- sin, liii— exc’t-ntin,z Lii 1011(1 i’ Slit) PCI (Oliti_il I 1k dt.latest bemg mr clt-hs en eighteen ninitli’ iii lie h,tuii’ setting iii ,uiti.tlbn’ iii sell ‘1(119

1)rnir lii lie dt-hsei

- . . - - date, it is possible to t,.,dr- in in’as’irs hifl hiloresI he size ol ca,-h c-out i ti I is I onlIne,. ‘mc tt’nos cit - _

- I I I . I qjntr’,u 6 ss-,W Inc Ic’s n,i,m -\ tI .,n ch,- ‘I no I iron Inc’Lice lace salne at motions - I Ills, is ~utlc ii ergot iu,i.rc’srieiitrat’ti, ret !\tamcli 1978 iIe.lsln-s- hills ~ a sali’ of _I~~ot (‘.i( Ii (flute-act.S-S n.illheme tel ibm ti’cic-ss’ei-k Tre c’in-~ bills to he delis Prices iii tIc ‘I mt’asi,n bill n;iikt-t on- 1

111-Itecl III

ered ri \iarc-h 1978 at arc ,IgICI’LI upon pm-ice Sino ihsennnt basis. that is.. t -l put-c’ h1~’.ci I han the i~’lath, a prn’c-h.tse oF tight intuit-s ,mtmt-ts of \luu—c s-slur. ~ prues iii the Ti-c-sins hill futures nc.imkct1978 l’r—easurr hills i.s a pun-hose if SM mceil]momi ~ arc’ ,aISI) ciim~tc’d(elm .c clisc-Ilnnt hutsrs. i’l,e intc-r-i’st c_-umrnnlIlni-tet’iewec-k ‘lrcascn-’- bills to hc dr’Ii~e-red in \l:uth on a l’reasor~ bill. ii lu-hI to maturik. is tIc,’ dill -rc’rtc-P

I 978 at .111 agreed rc~eume pi iii’. ii livId Ice delnt ~‘‘~ ll(’tss,I’e,, the ;sLlreliase p1 icc ,,r,cl lit’ luO-e diii lii

lutures (-ol,tra( t is settled In, the loisinr’s dun foilosv- pit-c’). Pikes in thc- [‘reason bill lottites iiiucikt’t Ireiug tie,’ last day of tm-ailing in the delis en- iiiorit}l.

1itcicited in tc’r is of the I \IM Iutc-i national \lcenetar>

Futures trading it rnnnates no the second lnlsiimess 1 iv Market; lodes. si ho Ii rt presents the diltei-erit-r let-—folhmiwneg tF,’ ireasun auction ol thrrc’—monil, bilk ‘~ wee:i the ‘I,’e-as,mm bill ‘. ic’ld cli~-loo,t - ore an -ciliclial

tie third wet-k el the delis en. nnenth. I-or c-sample, basis and PR) lair ‘. ahri’ ‘Cr ~ I Fur e~uInip]c’Man-h 197-S 1 cr-asur~ bill lutnn-s contracts ,crc’ ill-In •J’chlc’ I shosss thu Iretimies P~~’and ‘ic-Id quotations‘ic_cl ml. the 11111,1 ssec-k If \larch. ~siflr h. clc-lis’t’eecl br Treumsurs hills no Man1, 14. 1977. as puh]ishr’d b~

file Wall She, I Journal. The Marc-h 1977 intures prier- . . at the c-lose of tracluig tlic- set tlc’ia.’nt pike, 5’

‘D: loIs ; ~ i~t~°; ~ ;::,t;h,t1t1

5t cuy,amn. st 95 39 so h1t tilt mutt m st itt, S ( Id u ( di’u net

Rate-s. lreasun, Ri/I 1 utuw, -Chicago, i97h I, alit Intem— basis ciii tilt’ \1,irc-h 19 . cinch-ct v”.cs 1,61 pcI c-emitnateonal Minietan Mackit I)~sisiceim, Juhrna(i’nicel M.~nc— — - 95.39 - -

turn .UarAet h-a B10

k3973—7O I Chicago. l9,(i - Con--tiact ei,fr~i,ati,,i, ‘sos also

1no’ ;d-d lit the SIan’tit-ud .,— -~(

Departmiml oF tIct- Chic-ag, ~dc-rc.otil,- I ‘change. ~C.)epmu’nlztre.’ ifl 111(1 U flute-s. pp —1

interest-rate risk by individuals willing to bear suchrisk in return for the possibility of making a profit.2

Futures Markets, Information, and MarketExpectations

Trading in futures markets provides informationto the cash market about the commodity beingtraded.3 Prices of futures contracts for delivery of a

2For a discussion of the futures markets and the roles of hedg-ing and speculation, see Thomas A, Hieronymus, Economicsof Futures Trading: For Commercial and Personal Profit, 2nded. (New York: Commodity Research Bureau, Inc., 1977).

Uses of the Treasury bill futures market in tenns of hedg-ing and speculation are basically the same as those of themortgage futures market, In addition, a discussion of thecosts and benefits of the Treasury bill futures market wouldbe essentially the same as a discussion of the costs and bene-fits of the mortgage futures market, For such analyses of themortgage futures market, see Neil A. Stevens, “A MortgageFutures Market: Its Development, Uses, Benefits, and Costs,”this Review (April 1976), pp. 12-19.

a discussion of the effect of futures trading on infonnationin spot markets, see Chades C, Cox, “Futures Tradiog andMarket Information,” Journal of Political Economy (Deccm-her 1976), pp. 1215-37.

commodity at a future date provide market partici-pants with information as to the expected pattern offuture spot prices of this commodity. This is becauseinformation relating to the future state of the marketfor a particular commodity is utilized by market par-ticipants when determining the price at which theyare willing to buy or sell futures contracts,

If a trader projects that a commodity’s price willbe different in the future than at the present time,he will buy or sell contracts for delivery of the com-modity at some future date as if his projection werecorrect. Any trader who has better information aboutfuture spot prices than other market participants (orfeels that he does) can attempt to make profits bytrading on this information, with the result that suchinformation is quickly incorporated into the prices offutures contracts. Thus, the interaction of all tradersin the futures market provides price quotations whichembody the market’s expectations of the future spotprices that will prevail on various delivery dates.

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FEDERAL RESERVE BANK OF ST. LOUIS JUNE 1977

In the case of the futures market in Treasury bills,the yields on futures contracts indicate the pattern ofinterest rates expected by market participants to pre-vail in certain months in the future, given currentlyavailable information. Any expectation of future in-terest rates, however arrived at, utilizes informationabout the current and expected values of variablesthat are thought to influence the behavior of interestrates. Such variables include measures of the currentand future state of the economy, the supply and de-mand for credit, and the course of monetary andfiscal policy. The futures market in Treasury billsserves the role of a processor of this information. Asnew information about the course of key factorsinfluencing interest rates becomes available, it israpidly reflected in futures market prices.’

The expected interest rate for any date in thefuture which is embodied in the yield on currentfutures contracts is not necessarily the interest ratethat will prevail at that future date, Market partici-pants in the futures market do not have a crystalball that foretells the future perfectly. Their decisionsto buy or sell contracts are based on the informationavailable at the present time. As new information be-comes available, market participants may vemy wellrevise their expectations. The effect of new informa-tion — such as a change in the announced monetarytargets, new budget projections, revised projectionsof the strength of economic activity, new pricingpolicies by OPEC, and so on is reflected in changesin the prices of (and yields on) futures contracts.Consequently, changes in market expectations can beidentified by shifts in the pattern of yields on futurescontracts (futures rates). Sharp declines or increasesin futures rates can be identified as changes in the ex-pected level of future interest rates, Thus, a compari-son of the quotations on futures contracts at two dif-ferent points in time provides information on whether

4This discussion does not imply that the Treasury bill futuresmarket satisfies the “efficient market” hypothesis. In an “effi-cient market”, all available information is utilized immediatelyby traders (and potential traders ), new ioformation is ax-au—able to everyone at the same time, and new infonnation isimmediately incorporated into market prices and yields. Thediscussion in the paper implies only that some of the avail-able infor atioo is utilized by traders (or potential traders) -

and that nesv intonnatiou which is utilized is quickly reflectedin futures prices. This allows for information costs and imperfectinformation among market participants. For a general discus-sion of the “efficient market” model, see Oldrich A. Vasicekand John A. McQuown, “The Efficient Market Model,” Fi-nancial Analysts Journal (September - October 1972), pp. 71-84. For a theoretical treatment, see Eugene F. Fama, “Effi-cient Capital Markets: A Review of Theorx- and EmpiricalWork,” Journal of Finance (May 1970), pp. 383-417; orRichard Roll, The Behaeior of Interest Rates: An Applicationof the Efficient Market Model to US. Treasury Bills (NewYork: Basic Books, Inc., 1970).

market expectations have changed with regard to thefuture level of short-term rates. One implication ofthis is that it may be possible to assess the effect ofa change in monetary or fiscal policy on marketexpectations of future short-term interest rates,

Futures Rates and Expected Spot Rates

One way of looking at the price and yield quota-tions on Treasury bill futures contracts in Table Iis to interpret the yields on each futures contract asa market estimate of the three-month Treasury billrate that is currently expected to prevail in eachdelivery month. Thus, the market’s expectation onMarch 14, 1977, svas that the three-mnonth bill ratewould be 5,23 percent in June of this year, and wouldincrease another 126 basis points by December to 6.49percent. In comparison, the three-month bill rate onMarch 14, 1977, for currently traded three-monthbills, was about 4.57 percent.

However, such use of the Treasury bill futuresrates is subject to some reservations. The main ques-tion is whether the futures rates are unbiased esti-mates of the market’s expectations of future interestrates. According to the “nornial backwardation”argument of Keynes and I-licks, futures prices aredownward-biased estimates of expected future spotprices.5 This implies that even if future spot pricesare expected to remain the same as the current spotprice, the futures price will be below the expectedspot price by an amount equal to a risk premium.This premium is considered to he a return to specu-lators for assuming the risk of possible future pricefluctuations, and is larger for delivery dates whichextend further into the future, This implies, in turn,that the price of the futures contract will tend torise (the yield will fall) as the delivery date ap-proaches, provided there is no change in marketexpectations,

In terms of futures markets in Treasury bills, thetheory of “normal backwardation” implies that yieldson futures contracts are upward-biased estimates ofexpected future interest rates (since prices and yieldsof securities are inversely related). Accordingly, theinterest rate on three-month Treasury bills expectedto prevail as of some future delivery date is less thanthe yield quoted on the futures contract for that

5Johu Maynard Keynes, A Treatise on Money: The AppliedTheory of Money, vol. II (New York: Harcourt, Brace andCompany, 1930), pp. 142-47; and J. R. Hicks, Value andCapital: An Inquiry ivito Some Fundamental Principles ofEconomic Theory, 2nd erl. (Oxford: Clarendon Press, 1946),pp. 136-39.

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FEDERAL RESERVE BANK OF ST. LOUIS JUNE 1977

delivery date.° In addition, if yields on futures con-tracts are higher for later delivery dates than forearlier delivery dates, it is not certain that the ex-pected future spot rate is higher for the later deliv-ery dates than for the earlier delivery dates. This isbecause a larger risk premium is included in theyield associated with the later delivery dates. Only ifthe difference between the yields for an earlier andlater delivery date exceed the difference betweentheir risk premia can one conclude that the expectedfuture spot rate is higher for the later delivery date.

One implication of this line of reasoning is thatgradual declines in futures rates cannot necessarilybe identified as declines in market expectations offuture spot rates, since the yields on futures contractstend to fall as the delivery date approaches. How-ever, sharp declines indicate a change in expectations,as do increases in futures rates, provided the riskpremia are constant or change very little (which isgenerally assumed by the theory).

If these risk premia could be easily estimated,market expectations of future interest rates could beestimated from quotations on futures contracts. Unfor-tunately, this is not the case. In addition, other ana-lysts dispute the “normal backwardation” argumentand claim that futures prices are unbiased estimatesof expected future spot prices.7 The issues surround-

ing this question of unbiasedness are not within thescope of this paper, but some observations on thematter can be made.

Even if futures rates are biased estimates of mar-ket expectations, the bias will not be very large,judging from the estimates of risk premia embodiedin the yield curve.8 Furthermore, the bias, if it exists,is expected by most theorists to be consistent overtime, rather than being subject to large fluctuations.Consequently, even though futures rates may not beentirely accurate as point estimates of market expec-tations, it may be possible to make rough estimatesof expected future interest rates.

Table I

FUTURES PRICES FOR U.S. TREASURY BILLS ON MARCH 14, 1977Delivery Price Yiold~ YieldMonth - Open High Low Closo~ Change IDiscount’ O,anqr 7

Mo’cti 1977 95.37 95.40 95.37 93.39 H .01 4.61 .0!June 1977 94.73 94.84 94.71 94.11 .03 5.23 .03September 1Q77 94.10 94.16 94.05 94.10 - .0! 5.90 .01December 1977 93.52 93.56 93.46 93-3! -i- .01 6.49 .01Mardi 1978 9303 93.17 93.04 93.13 H .08 681 08June 1978 92.66 92.75 92.66 92.66 - 734

I in—h :1 t’,-n.,-n i-i iii--

—B, - sh-,_-~,,’i.-:—,-lti-.’,mi’-. 1-:-’:,- I ‘u-lu .o i’vrh_ -

- liLt ‘ I-~’i~11

F. MPL!I 1. 1-;:

Trading Volume

Another issue bearing on the usefulness of thefutures rates involves the amount of trading whichoccurs in each contract. Generally, it is thought thatthe larger the amount of trading in a security, themore representative the price and yield quotations

OHicks used the “nominal backwardation” argument of thefutures market in his development of the liquidity preferencetheory of the term structure of interest rates. See Hicks,Value and Capital, Chapters XI and XIII. In the literatureon the term structure, market expectations of future interestrates have been examined using the implied forward rateswhich are embodied in the yield curve. These implied for-ward rates are theoretically equivalent to futures rates.

tFor discussions of the issues involved and some empiricalevidence in support of nos-mal hackwardation, see Hendrik S.Houthakker, “Normal Backwardatinn,” in Value, Capftal, andGrowth: Papers in Honour of Sir John Hicks, ed. James N.Wolfe (Edinburgh: Edinburgh University Press, 1958), Chap-ter 7, and “Can Speculators Forecast Prices?” The Review ofEconomics and Statistics (May 1957), pp. 143-51. For evi-dence against the theory of normal backwardation, see Lester

C. Telser, “Futures Trading and the Storage of Cotton andWheat,” Journal of Political Economy (June 1958), pp. 233-55. Telser argues that prices of futures contracts are solelymarket expectations of future spot rates and contain no riskpremia.-

5Since such premia in the Treasury bill futures market will be,at most, for three-month bills eighteen months in the future,the bias in the yields on futures contracts will not be verylarge. This is due to the fact that the premia, according tothe liquidity preference theory, increase with term-to-maturityfor such Treasury bills. TIms, the premia associated withthree-month bills to be issued six months frosn today areexpected to be smaller than the premia associated with three-snonth bills to be issued one year from today. Estimates ofthese presnia have generally been less than 50 basis points.See J. Huston McCulloch, “An Estimate of the LiquidityPremium,” Journal of Political Economy (February 1975),pp. 95-119; Roll, The Behavior of Interest Rates, pp. 98-99;and Edxvard J. Kane and Burton C. Malkiel, “The TermStructure of Interest Rates An Analysis of a Survey of In-terest-Rate Expectations,” The Review of Economics and Sta-tistics (Amsgust 1967), pp. 345-55.

The existence of a bias in the futures rates can be testedby investigating whether, with constant expectations, theprices of futures contracts rise (yields fall) as the deliverydate approaches.

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FEDERAL RESERVE BANK OF ST LOUIS JUNE 1077

ToMe IIAVERAGE DAILY TRADING VOLUME BY MONTH

Cantresct Do ivery MonthTolol

Mont Mar I, June Sept nbc Dec mber March June Septers,be December Mar h Jun S prenber AlTraded 1974 1976 976 1976 1977 1977 1977 977 1978 1978 1978 llssu I

January 5976 52895 3475’ SI! 8 18872Febrea 1976 5889 .63 2 74 1271 134.86MacIs 1976 2746 19239 7 57 298 784 3869Art 1976 4176 12043 3900 500 30619Ma 1976 9200 2445 8460 1737 758 426,00one 1976 2647 23014 7 5 2736 5045 38197ely 1976 24243 25857 43.0 843 775 605 7624

Au~u,t 1976 6073 2350 6944 1150 23 241 41909Septensbe 1976 1967 85.43 10762 39,8! 4.00 3.10 200 36! 62October 1976 15971 290.71 16057 27.71 15.19 429 61819

November 1974 5 30 34565 31540 6775 2035 255 8 1.00December 1976 3 88 23 43 29481 12295 3690 1767 74064January 1977 21667 39848 30133 7471 3514 386 103019

February 1977 79 32 415 05 24226 88.0 17 2 8 76 8 0.56Mar Is 1927 3 .59 350.91 38504 7409 074 27.13 27.67 105317April 1977 2 65 51 45 523 25 72 0 75.7 4 85 156 .05

So ce I matson Maneta Market DivI ,s o (Ibsen a Mere a le Each n

will be of the market value of the securityY In thecase of Treasury bill futures contracts, this suggeststhat contracts with low trading volume are not rep-resentative of the market value of these contracts,and, hence, are not representative of market expecta-tions. However, the issue is more complicated thanthis.

As can be seen from Table II, trading in any par-ticular futures contract is low when it is first traded,increases over time, but then is again low as itsdelivery date approaches. For example, trading in thefutures contract for delivery in March 1977 can beexamined by reading down the appropriate columnin Table II. This issue was first traded in March1976, and the average daily volume of trading wasonly 7.84 contracts. By November 1976, trading in-creased to over 345 contracts per day. But afterJanuary 1977, with less than two months to thedelivery date, trading declined below 100 contractsper day.

As the delivery date approaches, trading volumegenerally declines because there is greater certaintyas to what the spot rate will be on the delivery date.That is, traders tend to agree as to the future marketvalue of three-month Treasury bills (their expecta-tions become homogeneous) when the delivery dateis near. Consequently, there is less risk of interestrate fluctuations to be hedged against and less likeli-hood that profits can be made from trading, so thatless trading occurs. In this case, the futures rates do

9This line of reasoning underlies, in part, the construction ofthe Treasury Department’s yield curves, which give greaterweight to the yields of some actively traded issues.

reflect the market valuation of the contracts, eventhough there is little trading.

However, a lack of trading may also he indicativeof a case where market participants have ill-definedexpectations of future interest rates and their expec-tations are so diffuse that traders’ bid or askedprices are not matched up with each other. In thiscase, there is little trading because there is greatuncertainty as to the range in which the future spotrate will fall. It is possible that this case applies tothe futures rates associated with contracts for deliv-ery in fifteen to eighteen months, such as the March1978 contract which was first traded in September1976 (Table II).

On the other hand, when market participants havewell-defined but heterogeneous expectations of futurespot rates, trading activity is likely to be large. In thiscase, traders tend to agree as to the range in whichthe future spot rate will fall, but disagree as to theexact value. Market participants perceive that thereis greater risk of interest rate fluctuations to be hedgedagainst, and that profits can be made from trading.Bid and asked prices on contracts for the deliverydate match up over a larger number of traders, andtrading volume is larger.

Therefore, the extent to which the yields on futurescontracts for particular delivery dates accurately reflectthe market value of these contracts, and market expec-tations of future interest rates, depends upon thedistribution of the expectations of traders. It is notsimply a matter of the amount of trading in eachcontract.

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FEDERAL RESERVE BANK OF ST. LOUIS JUNE 1977

The volume of trading also reflects on the Treasurybill futures market as a whole. The volume of tradingin futures contracts compares quite favorably withthe volume of trading in the spot market for Treasurybills. The total volume of trading in the Treasury billfutures market was relatively light during the firsttwo months of trading after its opening on January6, 1976. But beginning in March 1976, trading in-creased substantially to an average daily volume ofabout 318 contracts (Table II). With each contractrepresenting $1 million of three-month bills, thistrading represented the daily exchange of $318 mil-lion of Treasury securities in the futures market. Incontrast, the average daily volume of trading by se-curities dealers in the spot market for all outstandingTreasury bills (approximately forty different issues)was $8.76 billion during March 1976. These figuresaverage out to a daily volume of roughly $64 millionfor each Treasury bill futures market issue (fiveissues were traded in March 1976), compared toabout $169 million for each outstanding Treasury billissue in March 1976.

MARKET EXPECTATIONS OFSHORT-TERM INTEREST RATES

SINCE JANUARY 1976The pattern of yields on Treasury bill futures con-

tracts since the initiation of trading on the Interna-tional Monetary Market is shown on a daily basisin Chart I. Examining the snovement of these yieldsprovides some insight into the adjustment of marketexpectations of future short-term interest rates to newinformation about the state of the economy and thefuture supply of and demand for credit. The chartshows that the yields on all of the futures contractsbeing traded during any particular time period followthe same pattern of movement to a remarkabledegree.

During the first quarter of 1976, market expecta-tions of the future level of the three-month Treasurybill rate increased as the economy experienced a 9.2percent annual rate of growth in Real Cross NationalProduct (GNP). With the economy growing at sucha rapid pace, market participants apparently antici-pated a continuation of this upswing in economicactivity during the remainder of the year, althoughnot at so fast a pace. This expected strength in eco-nomic activity was translated into anticipations ofincreased demands for short-term credit, with a contsequent rise in interest rates. During March 1976, theyield on the September 1976 futures contract wasgenerally above 8.50 percent, while the currently

traded three-month Treasury bill yielded about 5percent.

The yields on futures contracts declined duringApril 1976, but by May yields had returned to roughlythe same levels as were recorded in March (ChartI). During most of April 1976, newly available dataindicated moderating pressures on the credit marketand expectations of future levels of interest rates wererevised downward. For example, the yields on theSeptember 1976 futures contract during April wereclose to 6 percent, down from about 8.5 percent inMarch. Data on the money stock (Ml) that becameavailable in the first half of April showed that themoney stock had grown at a 2.9 percent rate overthe first quarter of 1976, well below the FOMC’s an-nounced target ranges for Ml growth.’°Most marketparticipants apparently did not anticipate any near-tenn tightening in monetary policy actions, andviewed the gro\vth of money as being consistent witha continued gradual reduction of the longer-run infla-tionary impact of policy actions. The preliminaryGNP data available in mid-April continued to show aslowing in inflation and a strong surge in real outputgrowth. Business loan demand at commercial banksremained weak and Treasury financing requirementswere running well below earlier estimates.

Beginning in late April 1976, however, there wereseveral developments that acted to change marketexpectations. On April 22, market participants becameaware that there had been a very sharp surge in Mlin early April (money stock data is reported with aone-week lag). Data available in May indicatedthat the money stock was rising very rapidly, ex-panding at nearly a 17 percent annual rate in Apriland then at a 5.7 percent rate in May. On May 3 it

was announced that the FOMC had voted at its Aprilmeeting to lower the upper hand on the long-rungrowth of Ml from 7½to 7 percent.11 The FederalReserve moved to a more restrictive policy, and thiswas made apparent to market participants by a steadyrise in the Federal funds rate from about 4.78 per-cent in the week ended April 23 to 5.02 percent inthe week ended May 14. Then, at its May 18 meet-ing, the FOMC voted to adopt a Federal funds rangeof 5 - 5% percent, compared to a 4½- 5¼ percentrange at the April meeting. By the week ended May28, the Federal funds rate had risen to an average of

lOAlbert E. Burger and Douglas H. Mudd, “The FOMC in1976: Progress Against Inflation,” this Review (March 1977),pp. 2-17.

IlIbid. Rates of growth of the snoney stock used in this paperare the originally reported figures, not the subsequently re-viserl figures.

Page 7

0o

Yields on Treasury Bill Futures Contracts~kJanuary 1916 — April 1911

December

8.20

7.70

7.20

6.70

6.20

19115.70

5.20

1911

4.70 ~

December 19114.20’ r

1/6/76 1/29/76 2/24/76 3/18/76 4/12/76 5/6/76 6/1/76 6/24/76 7/20/76 8/12/76 9/7/76 9/30/76 10/25/76 11/18/76 12/14/76 1/10/77 2/2/77 2/28/77 3/23/77 4/18/71LL All yield s ,,,,o,c,di,cou, basis.

baste: l’l,,nolio,oI Mosesary Morhel Di,isio,

— June.1911

March,1911

March1918

June

1916

1916

1911

FEDERAL RESERVE BANK OF ST. LOUIS JUNE 1977

5,50 percent. As this new information about thecourse of monetary developments became available,market anticipations of future levels of interest ratesreturned by late May to about the same level as wasrecorded in March 1976.

The expected increase in credit demand failed toappear, GNP growth remained moderate, the inflationrate declined, and the unemployment rate increasedduring the summer of 1976. Growth of the moneystock fell to about a 3 percent rate from May toSeptember. Yields on futures contracts and the spotrate on three-month bills both declined slowly fromlate May until early October,’2 when the yields onfutures contracts fell quite sharply. This sharp declinewas reversed in late October when yields increasedalmost to their early September levels. This reversalin expected yields was also associated with incomingmonetary data that indicated a sharp surge in therate of growth of the money stock. From Septemberto October, Ml increased at a 15.5 percent annualrate.

Indicators of the strength of economic activity con-tinued to decline during the last quarter of 1976, asdid the rate of inflation, and market interest rates onall types of securities continued to decline. In the lasthalf of November, market expectations of futureinterest rates declined sharply. After the surge inMl growth during October, the money stock waslittle changed during November. But the Federalfunds rate declined from about 5 percent in earlyNovember to about 4.75 percent in early December,which, in turn, was interpreted by market partici-pants as indicating that the Federal Reserve hadadopted a somewhat less restrictive policy. DuringNovember, yields on futures contracts fell 50 basispoints or more. With pessimism about the “pause” inthe economy mounting, yields on futures contractsfor Treasury bills continued to fluctuate around theselower levels until the end of the year.

The increase in expected future interest rates inearly January 1977 coincided with the new Adminis-tration’s announcement of a stimulative fiscal pack-age. At the same tUne, data on the economic indi-cators for November were revised upward and astrong showing of some of the indicators for Decem-ber was reported. Furthermore, monetary actions wereno longer moving toward a further reduction in the

12Under the “normal backwardation” hypothesis, this gradualdecline in futures rates may not reflect a gradual decline inmarket expectations of future spot rates. Instead, such agradual decline over lime is consistent with constant marketexpectations of future spot rates, since if “normal backwarda-tion” holds, futures mates tend to fall (futures prices riseas the contract delivery date approaches.

Federal funds rate, contrary to the initial expectationsof many market analysts. As a result, yields on futurescontracts increased to their levels of mid-Octoberthrough early November.

From early January through March 1977, yields onfutures contracts were relatively stable. During April,when the Administration’s rebate program was can-celled and the energy program was announced, fu-tures rates fluctuated sharply. As new information onthe state of the economy and on future supplies anddemands for credit becomes available to market par-ticipants, the expected future interest rates that areembodied in the yields on future contracts for U.S.Treasury bills will be revised, Movements in the levelsof these yields will, therefore, provide a significantindicator of revisions of market expectations of futureshort-term interest rates.

SUMMARY AND CONCLUSIONSThe Treasury bill futures market provides a means

for hedging against interest-rate risk. Speculators areallowed the opportunity of making profits in thismarket in return for bearing the risk of future interestrate fluctuations. In addition, futures markets provideinformation about the expected future pattern ofprices. In doing so, indications of changes in marketexpectations of future short-term interest rates can beobtained. Although exact estimates of the expectedlevel of future spot rates may not be obtainable fromfutures rates without adjusting for a risk premium, anapproximation of the level is possible.

If it can be shown that futures rates are unbiasedestimates of expected future interest rates, the datafrom the Treasury bill futures market could be veryuseful in a number of ways. Policymakers would beable to readily assess the effects of policy changes onmarket expectations of future interest rates. Econ-omists and other researchers would have observablevalues for market expectations of interest rates, in-stead of having to use proxy variables for such ex-pected rates. Analyses of the portfolio behavior offinancial intermediaries, investment decisions of firms,and the term structure of interest rates are amongthe many areas of research which would be aided bythe use of such data. In addition, analysts who fore-cast interest rates would be able to compare theirestimates of future interest rates against the market’sexpectations. Since market expectations of interestrates are an important factor in many economic rela-tionships, the information on expectations containedin the Treasury bill futures market will be of increas-ing interest to businessmen, financial managers, pol-icymakers, and other economic analysts.

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