For Some Weather Forecasts and Economic Forecasts: About the Same Accuracy
It may be a good place to start our economic update in 2015 by mentioning a study conducted by Deutsche Bank Securities going back to 2003. It measured the accuracy of the survey of professional forecasters’i ability to correctly predict the interest rate on the 10-Year Treasury one year into the future.
The study indicated that the average 12 month forecast was 60 basis points too high and in some years much higher than thatii (the survey forecasted interest rates to go up and they actually ended down).
So goes the forecast for 2014. Ryan Sweet, Director at Moody’s Analytics, forecasted the 10-Year Treasury yield to be at 3.65% at the end of 2014iii, other forecasts were between 3.25 and 3.50%.iv Where is the 10-Year treasury yield at the time of this writing? 2.27% as reported by Bloomberg.v That is 1% lower than the forecast. True to the forecasting study in 2014 when interest rates were forecasted by most to go up, 10-year interest rates fell. We don’t want to be too hard on the survey of professional forecasters. It appears they will be fairly close in predicting other 2014 end of year economic measurements. They got gross domestic product (between 2.5 and 3.0%), consumer price index (between 1.7 and 2.0%), and came close on unemployment (between 6.0 and 6.5%).
Take a guess on the interest rate forecast for 2015… rates are forecasted to go up. The survey of professional forecasters predict the 10-Year treasury to be 3.25% at the end of 2015.vi That is 1% higher than we are today.
At Mark H. Smith we have noted the significant increase in real estate lending for many of our clients. Some credit union loan portfolios now have more than 50% allocated to real estate loans. This is a significant change from the past. What does this mean for credit unions? Well, for starters, more interest rate risk. Credit union real estate loan portfolios tend to have longer maturities than their historical auto loan portfolios. For credit unions this is not necessarily a bad thing. There are many real estate loan types and structures that we have seen our credit union clients successfully use to limit interest rate risk. Examples include variable rate HELOC’s and ARM’s, dollar cost averaging loans over time, and length of term loan limits.
In addition to increasing real estate lending, we have also noted that several of our credit union clients have extended the maturities on their investment portfolios as well. A popular strategy for some has been to purchase long (7-20 year maturity and longer) callable bonds because of the higher yields available there. Over the last 4-5 years this long maturity callable bond has worked, particularly because interest rates have stayed low and many of the callable bonds have been called early. What does longer maturity investment portfolios mean for credit unions? Similar to the increased real estate lending… it means more interest rate risk. Again, for credit unions this is not necessarily a bad thing. We have seen credit unions successfully limit interest rate risk by dollar cost averaging their bond purchases, spreading investments over several different asset classes (CDs, Treasuries, Agencies, Municipals) and making sure to adhere to their investment policy with maturity limits.
If the interest rate forecasts are more accurate for 2015, then the real estate loans or other longer term loans that you made in 2014 will look a lot less attractive. If the 10-Year Treasury rate were to revert to its historical mean of 4.62%, then your credit union could be holding lower interest rate loans for years to come.
Although predicting interest rates can be as reliable as predicting the weather, there are some elements that credit union managers should take note of in managing interest rate risk. If there is a take away on the forecast of interest rates (and the forecast for weather patterns), the further out in maturity the more volatile the rate and the more difficult to predict. Interest rates on 2-5 year term auto loans are going to be less volatile than 5-15 year term real estate loans.
As we have for many years now for our clients, we aim to continue to assist you in measuring these risks. Please don’t hesitate to contact us with questions or help that we can provide specific to your portfolio.
10 year treasury rate quoted on Bloomberg.com December 23, 2014