Tuesday, March 17, 2015

Interest rate forecasts have been wrong



An informative Bloomberg chart and video compared the actual 10-year yield with the consensus forecasted yields as represented by the green dashed line. All forecasts have been expecting increases in yield. Those yields have generally never been realized. Forecasters get it wrong with the long-term interest rates. 

Forecasters have expected the Fed to raise rates by now. It has not. Deficits have not mattered. Inflation expectations have been too optimistic. Growth has been slower than expected, and risk premiums have come down almost to zero. Analysts have gotten all of the parts of wrong with respect to nominal interest rates, so it should not be surprised that the forecast have been wrong. 

Forecasters have been waiting for the the big fixed income rate raise and it has not happened. Recent forecasts have been even more biased upward. These expectations may be realized but not because of skill. It could just be luck that rates will at some time rise. Albeit you may not even want to bet on that.

Why focus on the errors of forecasts? It does not make me feel good to say we cannot forecast well, but it does impact how portfolios should be constructed. Diversification is still the foundation of good portfolio management. We will get forecasts wrong, so it is critical to focus on broad construction. That said, can tilts be placed in a portfolio based on risk premiums, trends, and market cycles? The answer is yes, but all things should be tempered.

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