What Is the Terminal Rate?

What is the terminal rate? It is the peak level markets expect a central bank’s policy rate to reach in the current hiking cycle. In a cutting cycle, the same idea applies to the expected floor.

The central bank does not publish it. It is priced into interest rate futures and swaps, and it moves with every inflation report, jobs report and policymaker speech. Who sets the rate at each bank is on The central banks.

Why the end point matters more than the next step

A single quarter-point hike is usually priced well before the meeting. What moves a currency is a change in where the whole path ends. When the expected peak rises, every meeting between now and the peak is repriced at once.

An example with invented numbers:

• Markets expect the Fed to stop at 4.50% and the ECB at 2.50%.
• Two US inflation reports in a row come in above forecast.
• The Fed’s expected peak moves to 5.00%; the ECB’s stays where it was.

Neither bank has done anything yet, but the expected gap is half a point wider. EUR/USD tends to drift lower over the following weeks. Today’s gaps are on Interest rate differential by currency pair.

What moves the expected peak

Anything that changes the outlook for inflation and growth: inflation reports, labour data, and above all the central bank’s own words. The Fed’s dot plot shows where its policymakers see the peak. In practice, a hawkish surprise is anything that lifts the expected terminal rate.

How it differs from the neutral rate

The neutral rate is the level that neither speeds up nor slows down the economy. The terminal rate is where this cycle is expected to top out. When inflation is the problem, it can sit well above neutral.

Neither is an official number. A central bank’s own projections can differ from what markets price.

Comparing two currencies

The terminal rate is most useful in pairs. A pair tends to trend when the two expected peaks move apart, and to move sideways when they move together.

Today’s priced peak is not a forecast that must come true. It shifts with each release. When a release moves the expected peak and the pair barely reacts, that gap is worth noting.