There is a cottage industry in the business of forecasting markets. It is meant for entertainment, not for advice.
It began with newsletters, then with radio shows, then with televisions shows, even cable networks. Now websites. There are conferences dedicated to the subject. But, In the immortal words, of William Goldman in his Hollywood memoir: “No one knows anything.”
It seems useful to hear forecasts, but all too often in my career, I have had clients ask: “What does [insert your favorite bank name] say about the markets. I am telling you, it’s all there for entertainment purposes. Show me one company or one sophisticated investor that bases their real money investment decisions upon a talk from their investment company’s “strategist” or “economist” and I will show you an investor who has no investment process. These are almost never accurate. If they are, it’s purely by coincidence.
My best story is a presentation a group of top portfolio managers at a previous firm that I had the honor to be chosen to join. We were hearing a presentation by a well known “strategist.” After the presentation, naturally there was a question-and-answer period. One salty old veteran portfolio manager who often said awkward things stuck his hand up in the air and was acknowledged: “[Mr. Strategist], do you actually manage any money?” [Answer] “No.” The room was filled with silence.
Ten years later , the successor strategist with my firm did a talk for me and my partner and our clients. In the Q and A session, which followed, that strategist with the seven figure salary —in a weak moment —admitted to the crowd that the best forecaster of future events is “the yield curve.”
So, what is the yield curve and why is it so useful?
The most liquid category of securities in the world is the United States Treasury Security Market. Despite criticisms by politically motivated so-called experts, US Treasury bills, notes and bonds are still considered the literal gold standard of securities with absolutely zero credit risk globally. As such, over the term of maturities, from 30 days to 30 years, the amount of interest one is willing to accept for that period is the secure interest rate. No credit risk. If you create a graph with the “x” axis being time and the “y” axis being interest rates and graph the interest rates of US treasury securities over time from 30 days to 30 years, you can get an idea of what real investors believe interest rates will be over that time span.
Interest rates are very, very closely tied to what both stocks and good-and-services will be priced at over that time frame. As such, yes, the best forecaster of future events isn’t that guy reading the teleprompter on TV, the lady on the clever web site, or on the radio. It is the yield curve. When short term rates are higher than long term rates, a recession is coming.
Drafting off that concept, there is always speculation about inflation. All of us with the Jimmy Carter Administration still in the cobwebs of our minds think that somehow, some way that era of high interest rates will return. This memory is especially poignant when there are budgets deficits and trade deficits to deal with, and such.
Using Treasury Bonds to see future inflation
In addition to the term treasury markets, where you accept a certain fixed interest rate over a term of years, there is also the Inflation-protected treasury market. One of the Clinton Administration’s Treasury Secretaries, Robert Rubin, introduced the TIPS market—Treasury Inflation-Protected Securities.The TIPS market offers a series of term bonds where the interest rated is adjusted semi-annually to reflect the CPI-U, the urban consumer price index or inflation rate.
If one takes the difference between the term treasury, let’s say the 10 US Treasury rate, and the 10 year TIPS rate, that difference in interest rate—or “Treasury to TIPS spread” is a real-money indicator of what investors are willing to pay, inflation rate12. This Treasury to TIPS spread is what one must pay attention to for forecasting inflation, not what some “strategist” or “economist” says at a cocktail party to impress their company’s clients between martinis.