Wednesday, December 2, 2009

What Will Happen to Interest Rates?

There is no shortage of commentators making predictions about interest rates. This is because they can get the attention of just about anyone who has investments. Those who depend on interest income want higher rates, and those who have stocks and bonds generally prefer dropping interest rates.

It is possible to predict interest rates with better success than flipping a coin, but not in any useful sense. The market’s prediction on interest rates can be found by examining the current yield curve, which is a chart showing short-term and long-term borrowing interest rates. Typically, yield curves focus on government borrowing costs in the form of bond interest rates.

The Bank of Canada maintains data on yield curves going back to 1986. Here is the most recent yield curve data for the last day of August:



Typically, short term rates are lower than long-term rates because investors demand a higher return when their money is tied up longer. So, the yield curve tends to slope up.

Sometimes the yield curve slopes up by less than usual or even slopes down. This amounts to a prediction by the bond markets that interest rates will drop in the future. If the yield curve points up more than usual, this is a prediction that rates will rise in the future.

The problem is that these predictions are already built into the prices of all equities. If you become a yield curve expert who can see what a particular yield curve says about interest rates, you won’t be able to use this information to exploit market inefficiency because it is essentially the market that made the prediction. To make money, you need to know something that everyone else doesn’t know. You need to know something indicating that the yield curve is wrong in some sense.

I’m sceptical that anyone can predict interest rate changes over the next few years any better than the implied prediction of the yield curve. Even the Bank of Canada can’t reliably predict what world events will cause it to raise or lower rates. This is why I rarely listen to talking heads making interest rate predictions.

5 comments:

  1. I agree that it's hard to profit from predicting where interest rates are going.

    Note that when the yield curve slopes up less than expected, this is also prediction that inflation will be less than usual.

    Btw, just as a point of interest, the bond market in the UK in the 1800's typically had an inverted yield curve where short term interest rates were typically higher than long term rates. Presumably this was because inflation was not an issue and long term rates were more stable than short term rates. Investors demanded a premium for taking on short-term bonds with fluctuating short term rates. It makes me suspect that maybe most of the reason for a sloping yield curve today is to compensate investors for inflation.

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  2. The other problem is that many interest rate decisions have little to do with Economic Theory and more to do with Political Aspirations. If China decided to raise their rates tomorrow (which they could), what would happen (aside from bankrupting the U.S. government)?

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  3. I believe it was Eugene Fama who cited in a research paper that the best predictor of future interest rates was indeed the current yield curve, for all the reasons you mentioned.

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  4. Well said. I believe your comments apply to investing in general as well as interest rates specifically. No one can predict the future. Listening to those who try can be really confusing, as you can always find valid arguments for both sides. It's almost like you need to approach investing as you would a strategic game. Try to eliminate as much risk as you can by having a plan for various scenarios. Thanks for the post!

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  5. Blitzer68: You're right that it isn't the absolute shape of the yield curve that matters, but how it differs from its expected shape. The UK's 19th century usually inverted yield curve is an interesting one to try to explain.

    Big Cajun Man: Interest rate decisions can definitely become political. China still holds less than 10% of the US debt. They could cause the US some problems if they wanted to, but their influence is less than many believe.

    Preet: Thanks for the pointer to Fama. I might take some time to see how to actually make a prediction of future rates given a yield curve. It's true that the fact that the yield curve predicts future interest rates is well-known to economists. On my path to financial enlightenment, I like to do my small part in bringing truth to the masses :-)

    2 Cents: I agree that not listening to talking heads when it comes to interest rates extends to stock picking and other areas. Thanks for the kind words.

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