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Interest Rate Forecasting in a Volatile Time

A Time Machine? Really? OK, Keep Going.

This past weekend, I saw a decent movie… Hot Tub Time Machine and one of the running themes in the movie reminded me of the shift in the bond market last week (and what our immediate future looks like). Without giving away the whole movie, I want to explain….

In the movie Crispin Glover plays a bellhop at a ski resort.  When we are introduced to him, it is 2010 and he has lost his right arm.  As the story unfolds, the main characters go back in time to 1986 to the same ski resort.  Here we see our bellhop with both limbs, fully functional.  There are numerous episodes with chainsaws and nasty elevators that put the bellhop’s limb in danger.  Because we know the eventual result, each time we have a heightened anticipation (as do the time travelers in the movie) that “this is the moment when it happens”– but then it doesn’t happen.  We almost feel disappointed for a moment, but then things ease back to normal.

I see that as a metaphor for the bond market today.  We all KNOW rates are going up….and up significantly (just as surely as our bellhop will lose his limb).  This space has given all the WHYs for months (end of the Fed’s MBS Purchase Program and inflation being the main culprits).  The real questions now center around “WHEN will it happen?” and “HOW DRAMATIC will the movements be?”

With the uncertainty of WHEN and HOW DRAMATIC, we enter the world of bond trading.  In their world, every day, every hour, heck every minute is a gamble.  If rates move up OR down with any significance, millions of dollars can be made or lost.  Understand that MBSs have a fixed rate of return (weighing in many factors like interest rates, loan types, length of the loans, insured or not, and so on). When rates go up, we know future MBSs will have more value because the yield will be higher, right?  That forces the price, that current MBSs can be sold for, lower (because the yields are less attractive).

Back to being a bond trader.

In this environment, you are sitting on the trading floor pumped with caffeine (or worse), wondering when will be the exact moment when the market is going to collapse around you.  You stand with your finger on the trigger, looking for any crack in the foundation, any news that can give you an advantage on when to buy or sell.  You live in a state of heightened anxiety.  You wonder what happens on April 1st (after the Fed exits).  You wonder about every economic report that could hint at inflation rising (jobs, CPI, PPI, PCE, and more).

Then, another trader sells more than normal.  You panic.  “What did I miss?”  But in this microwave world, you know taking the time to figure out what happened can leave you holding the bag.  So, what do you do?  You start selling too.  Then, someone else gets on the bandwagon.  Suddenly, prices are collapsing (rates are climbing dramatically), not based on any real data, but because the momentum of fear has started an avalanche.  Such is the way in a world of heightened anticipation and instantaneous access to information.  But then, the next day, after the dust settles, all the traders see that they overreacted and prices begin to slowly climb back to where they should be.

We saw it all happen last Wednesday afternoon.  With weaker than expected Treasury Auction results (added to the already unstable environment), we saw a selling frenzy (bond prices falling 87.5 basis points).  On Thursday, pricing continued to tumble early, but then recovered and finished flat for the day.  Friday and Monday saw modest gains, gaining back almost 40% of what had been lost.

My friends, as the Fed exits, we return to the frightened landscape that existed when the Fed began their aggressive purchases of MBSs.  In a scared market, rates will shoot up quickly (because of the fear of losing too much) and decline slowly (for fear of it not being sustainable).  We are in a “lock your rate if you like it” mode.  Don’t gamble on getting lower rates because the 1/8% you may gain, isn’t worth the risk of the ½% you could lose.  Volatility is the enemy of predictability because volatility is driven by emotion…..and emotion in business can cost you and arm when you least expect it.


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