Intuitive Analytics

Intuitive Analytics frees public finance analysts and decision makers from the limitations of available software.

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Why Forward Rates Should NOT be Used in Forecasting

  
  
  
  
  

“It is exceedingly difficult to make predictions, particularly about the future.”

                                - Niels Bohr (Danish physicist)

Forecasting is a difficult though necessary evil in finance. So what rates should be used for forecasting? We strongly believe that when forecasting market variables, entire distributions should be created and not just single point estimates.  Nevertheless, what should be the “center” of the distribution or our true expectation? We see too many bankers relying on forward rates as if they were the holy grail of market forecasts when in fact, forward rates are appropriate to use in only ONE specific case for one type of market player.

describe the imagePerhaps the greatest breakthrough in financial engineering is the concept of pricing assets in
a “risk-neutral” world. Skipping the unnecessary details, this idea essentially allows us to conclude that, in complete and arbitrage-free environments only, we can assume that all securities will earn the risk free rate of return. This dramatically simplifies asset valuation in arbitrage-free markets. 

What types of environments are arbitrage-free? The closest thing we get in public finance are the swap markets. That’s it. For everyone else (investment bankers, financial advisors, issuers and even investors) forward rates are interesting but simply inappropriate for use in forecasting. It’d be nice to have a simple calculation to do see what the future is most accurately expected to be, but the Real world and the Risk-neutral one are fundamentally different and should not be confused. 

50 Years of USTNote History - Is Default the Next Event on the Chart?

  
  
  
  
  

"More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly."    - Woody Allen

Milton Friedman argued in this 2003 WSJ op ed piece that though the Fed's performance for the first 70 years of its existence left a healthy dose of room for improvement, over the years since about 1986 the Fed's thermostat was honing in on a Goldilocks temperature: policy was getting just about right. I'm not sure how much I agree. I'm a believer in the nature of human history being at its core (unfortunately) repetitive, particularly when it comes to economic cycles.

As we sit in the longest run of monetary expansion in this country's history, thought it’d be interesting to offer a long view of long rates using everyone’s favorite benchmark, the 10 year Treasury Note.

 50Y of USTnote yields

The chart shows UST Note yields starting in January, 1962 up through June 28, 2011. Back in the early 60s when the gold standard imposed some discipline we had yields that are very close to where they are today, though with far less volatility. From there, if you look closely you can see the yield dips associated with these events:

Will a technical or other default on US Treasuries be the next event?  Which way will yields go? How does a flight to quality work when the canonical “quality” asset is defaulting? I'm hopeful we won't find out though I'd say the chances are about 50/50 at this point. 

Over the next few weeks we’ll put up some posts looking at yield curves more quantitatively and ultimately, how they can inform relative value and borrowing strategies for tax-exempt issuers.     

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