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Forecasting Interest Rates: Mission (Im)possible?

Forecasting interest rates is an important exercise for any portfolio manager or investment strategist. The future direction of interest rates dictates the future prices of bonds and the equilibrium of cash flows between the two major asset classes - bonds and stocks. Central banks around the world gather periodically to assess their respective inflationary pressures and employment statistics. Reading the interest rate tea leaves seems difficult - at best!

Bond Market Structure

There are two main levers to consider when we think about the bond market - credit risk and duration risk. Credit risk is the estimate of how likely we (as investors) will get our interest payments on time and the probability of recovering our principle at the end of the bond term. Credit risks can range from very low (AAA rated) to very high (DDD rated). Duration risk is the estimate of how much a bond price will change between its birth date and its termination date. Shorter duration bonds will have lower risk (partly due to the fact that an investor is more likely to hold the bond until termination), while longer duration bonds will have higher price uncertainty and may be sold as the investor realigns their portfolio.

The credit risk spectrum deserves a closer look. The US Dollar has enjoyed the role for the past almost 80 years as the default global currency. The stability of our democratic process and strength of our capital markets has allowed our suite of Treasury bonds to be viewed as a very low credit risk. This has attracted investors from every corner of the universe whenever there is a flight to quality. Because of this low risk, US Treasury bond rates are effectively the foundation of the global credit markets. There is the old saying that when the US sneezes, other parts of the world get the flu. Here is a snapshot of the Treasury yield curve at 5:00 PM today.

The FOMC Decision

The Federal Open Market Committee (FOMC) just completed their two day meeting and announced that they would keep their target rate set within the 0.00% to 0.25% range. Their written statement suggests that they think recent inflationary pressures can be explained by temporary disruptions to the supply of goods and services due to the ongoing pandemic. Once these disruptions have passed, the FOMC will remain comfortable with inflation running at an annual rate above 2% over the short term before settling into a longer term rate of 2%. This suggests that the target rate may be adjusted upward sometime in 2022 and that it may (finally) approach a normal range around 2% within the next 2-3 years. The FOMC has one other "lever" to pull in the quest to maintain price stability and promote full employment: asset purchases. The US Treasury has been buying back bonds since the credit crisis of 2006-2008 in an effort to provide both market liquidity and price stability in the bond markets. The FOMC statement hints that these purchases may no longer be necessary starting fairly soon. Many market participants have shown concern by calling this expected action the "taper tantrum."

Leads And Lags

In a recent presentation, an advisory firm showed a chart with the yields of the 10-year Treasury Note over the past several decades. They then calculated the 10 year rolling total returns of these investments and placed the lagged results on the original yield history. The strong correlation between these two metrics was evident by the similar values and patterns over time. Two reasons for this immediately come to mind: the low AAA credit risk of US Treasuries and the possibility that 10 years may be a good proxy for an average market cycle. We were curious about these correlations, so we crunched some numbers of our own. The following two charts show the expected (e) and actual (a) forward returns for intermediate (5-year) and long term (20-year) government bonds respectively. The correlations came in at 0.93 and 0.90 for these two series starting in April 1953.

What We Think

When it comes to bonds, we think it is very tempting to overthink the future. We prefer to adhere to the KISS (keep it simple, stupid) principal by taking the current yield of bonds as the implied prediction of their annualized total return over their term. We do this at the asset class level, and for individual bonds. The next step in this process is to reduce these expected returns by the default probability and - in the case of a bond fund - the expense ratio.

Resources

https://www.investopedia.com/articles/forex-currencies/092316/how-us-dollar-became-worlds-reserve-currency.asp

https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/TextView.aspx?data=yield

https://www.federalreserve.gov/newsevents/pressreleases/monetary20210922a.htm

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