Introduction

Readers of our site know that we give little credence to stock market timing; see Beat the market? on our site. If someone were to tell us that stock market’s are about to plunge and to liquidate our entire stock portfolio and go 100 % into cash, we would politely change the subject of conversation; see for an example of such a recommendation, Ritholtz .

But should we take a different position when someone predicts higher future interest rates, and advocates selling all our bonds and going 100% into cash? In this commentary we look at why it is next to impossible to predict future interest rates and the implications for structuring your bond investments.

Economic forecasts

Like any other price, interest rates are the result of thousands of individual lending and other decisions which, in the aggregate, set interest rates. In a perfect world, could future interest rates be accurately predicted? It is very unlikely.

Interest rates are principally driven by economic conditions in general and the business cycle in particular in the jurisdiction of the relevant currency. So, this begs the question of whether future economic activity can be accurately forecast.

The inability to forecast interest rates is the focus of the next section. Readers who already (really) accept this can skip to the following section.

The dismal science

There is good reason why economics is called the dismal science; see Wikipedia for the origin of this term . Few economists can accurately predict future GDP numbers, and it is almost impossible to identify in advance those who turn out to have been the best forecasters. Perhaps Econobrowser has best summarized the situation:

Don't ask for too much of your forecast or your policy, and it won't disappoint you. Source: Econobrowser or as a PDF doc.1677.

l Few economists accurately predict recessions or other major economic turning points; see Swedroe Why You Should Listen to Economic Forecasts With Caution   or as a PDF doc.1678
and How Much Value Do Economic Forecasts Hold? or as a PDF doc.1679.
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Most economists even seem hesitant to forecast at all for periods greater than two years, which is no great help for investors trying to divide their investments among the short, medium and long term; see Ulbrich or as a PDF doc.1680.
The Swedish central bank Riksbank Blix et al in 1991 published one of the most thorough studies of economic forecasts or as a PDF doc.1681.   Its principal conclusion was as follows:

Forecasters appear to have had much greater difficulty in assessing growth than inflation during the last decade. In the US and Sweden there has also been a general overestimation of inflation and underestimation of growth. There are indications in several countries that forecasters have been unable to identify structural
changes in growth patterns even after prolonged periods of time. There is also some evidence of herd behaviour amongst forecasters, with a tendency to follow the same revision patterns. But this pattern can arise from quite “legitimate” reasons
as well, although it is beyond the scope of this study to determine which explanation has more merit.

See also the discussion by Forbes magazine of the institutions identified in the Swedish study or as a PDF doc.1682 as having made the best forecasts over the relevant period. Unfortunately, there is no reason to believe anyone identified these best-performers in advance.

Always, the unexpected

Economic forecasts are often derailed by unexpected, difficult to predict events; see Keong or as a PDF doc.1683.   .

Despite all the most sexy computation techniques used by economic forecasters, there are times (in fact, quite often) when forecasts produced by the best economic forecasters deviate too much from the actual outcome. One of the main reasons is that economic models are bad at capturing unexpected turning points, such as stochastic shocks arising from political crisis, wars, natural disasters, bank runs etc. These events usually arise without early warning signs; hence, most standard economic models are unable to capture relevant information during such idiosyncratic episodes. As Paul Samuelson commented “The stock market has forecast nine of the last five recessions”. His quote clearly illustrated the difficulty of predicting future economic event.

And economists refuse to apologize for not predicting in advance these events:

But I got my answer and it is the answer by which I am perplexed. From what I can tell, the world's macroeconomists have engaged in just about zero reflection on the flaws in their own models that caused them to be so terribly wrong in 2008. In essence, they are saying: "Our models are just fine. The 2008 economic crash was a random, outlier event that will happen regardless of how good our models are. It is not a commentary on the quality of our models, but on the variability of life on the planet." Maybe; but I am afraid that I am not convinced. It seems to me that given how terribly, terribly wrong they were, the macroeconomists would be wise to revisit their mindsets, models and tools and ask: "What did we learn from the 'outlier' event. Maybe it wasn't actually an outlier. Maybe it could have taught us something important about the things to which we are now blind but which are actually critically important." Source:  Martin 2009.   Source: Martin 2010 or as a PDF doc.1684.

The consensus

Because so few economists regularly successfully predict the future successfully, and even fewer can be identified in advance, the safe thing to do is to fall back on consensus forecasts, which to us is more or less an admission of defeat; see Consensus Economics . And it turns out that even using consensus averaging can be of limited value:

Using published interest rates forecasts issued by professional economists, two combination forecasts designed to improve the directional accuracy of interest rate forecasting are constructed. The first combination forecast takes a weighted average of the individual forecasters' predictions. The more successful the forecaster was in past forecasts at predicting the direction of change in interest rates, the greater is the weight given to his/her current forecast. The second combination forecast is simply the forecast issued by the forecaster who had the greatest success rate at predicting the direction of change in interest rates in previous forecasts. In cases where two or more forecasters tie for best historic directional accuracy track record, the arithmetic mean of these forecasters is used. The study finds that neither combination forecasting method performs better than coin-flipping at predicting the direction of change in interest rates. Nor does either method beat the simple arithmetic mean of the predictions of all the forecasters surveyed at predicting the direction of change in interest rates. Source: abstract of Greer article 2005 or as a PDF doc.1685.  

Bottom line: if your adviser, or an article in your local paper, your central bank or your Minister of Finance tells you that he really, really knows next year’s growth rate, much less the growth rate in 2, 5 or 10 years, be skeptical.