How Can We Make a Forecast For Interest Rates?

I find it very interesting to observe how economists and market experts
make interest rate forecasts. There are many respectable experts that make
forecasts for one, two or even three years into the future. However, the men and
women appointed to positions at the Bank of Canada, the U.S. Federal Reserve
Board and other central banks who actually determine the level of interest rates do
so in a different manner. Central bank officials usually meet every two months or
so to review economic and market conditions and then make adjustments
accordingly. In effect, they are flying by the seat of their pants. They are flying by
the seat of their pants because they have to. No one knows precisely what can
happen even a few months into the future. So, the best that these wise,
experienced officials can do is analyze conditions every two months or so and
then respond accordingly. They do have an idea of what interest rates might do in
the longer-term but they only respond to the here and now. They do not make a
projection for the future interest rate changes and stick to it. It is a fluid situation.
In fact, there have sometimes been changes to interest rates in between meetings
to react to an unexpected event like the 1987 Crash and Covid.

I can imagine that business owner and investors would like to have longerterm
forecasts for planning purposes. However, a 30-year study done by WSJ in
2016 showed that U.S. interest rate forecasts for the next six months were only
accurate 36% of the time. Consequently, there is strong evidence to suggest that
relying on economist forecasts for interest rates is not useful at all. If all of these
forecasts are not useful, what can investors and business owners use a guide to
determine where interest rates might be in the future?

I have found that one of the best ways to have an idea of the future direction of
interest rates is to look at the interest rate on two-year government bonds. This
interest rate/yield on these bonds is determined not by the logic of experts but by
investors voting with their money in the bond markets. The bond markets provide us
with the verdict of all of the bond investors after they have factored in all of the
variables.

So, let us look at U.S. bonds first. Bond markets are almost ten times the value or
size of stock markets. Most of the time, the Bank of Canada needs to keep interest
rates in Canada similar to interest rates in the U.S. to protect the value of the Loonie.
As a result, what happens south of the border has a significant impact on Canadian
interest rates. The chart below (from MarketWatch) shows that the yield on the U.S.
2-year bond has risen from 0.25% a year ago to a high of 3.42% on June 14th. Now
the yield is close to 3% at 3.04%.

A year ago, the Fed Funds Rate set by the Federal Reserve was 0.25%. Today,
after several rate increases, the Fed Funds rate is at 2.5%. This suggests that bond
market participants believe the Fed should raise interest rates another 0.50% or 50
basis points to keep inflation in check. We must always remember that no one has a
monopoly on wisdom. Central bank officials respect what is happening in the bond
market. It was only a few months ago that the expectation was that interest rates
would have to rise another 1.5% to 4% in the near future. Now, only one more 50
basis point increase might be enough for the Fed Funds Rate to be where it needs to
be. The mandate of the Fed is to keep inflation at a low level and maintain full
employment. Sometimes, the goal of full employment has to be sacrificed in order to
have low inflation. Time will tell if the interest rate increases this year will affect
employment levels down the road. The latest data out today showed the U.S.
economy still added 528,000 jobs amid expectations of adding 250,000 jobs, so
this is not showing signs of an economic slowdown.

The second bond we can look at is government of Canada 2-year bonds. The
yield on these bonds is slightly higher than the U.S. bond. The likely reason for
this is because global investors believe the U.S. dollar and US government bonds
are higher quality than the Canadian dollar and Canadian bonds.

The yield on this bond also peaked on June 14th, but at a slightly higher rate of
3.47%. The current interest rate or yield is at 3.16%, a decline of 0.31% from the
peak. On July 13, 2022, the Bank of Canada raised interest rates by 1 full percent
to 2.5%, the largest interest rate increase since 1998. This is now only 62 basis
points below the current level of the yield on the 2-year bond. This also suggests
that the Bank of Canada may be finished raising interest rates after one more 50
basis point increase at the next meeting on September 7th. (The Fed meets on
September 20th and 21st.)

It seems as though interest rates should rise another ½ of one percent next
month. However, that is reacting to inflation that has happened in the past. The
price of oil and other products have come down in recent months. While higher
rates may reduce inflation, it can also reduce economic growth 6 to 12 months
into the future. It takes a long time to see the impact of changes to interest rates.
Since it is unlikely that another pandemic and military invasion that has such an
impact on commodities will happen again in the next year, the level of inflation
could be low by next April. There could even be deflation by then.

It is harmful to have unnecessary interest rate adjustments. Raising interest
rates now only to reduce them a few months from now makes it difficult for
business owners and individuals to plan ahead. Nevertheless, domestic and
international investors want to know that a central bank will have the resolve to do
whatever it takes to keep inflation in line in order to protect the value of a
currency. Perhaps for this reason alone, the Bank of Canada and the Fed could
move rates higher by more than 50 basis points by the end of the year. If they do,
it will at least give them more ammunition to combat a slowing economy in the
future. However, it could also harm their reputation and credibility if they have to
lower rates shortly after raising them. There are many variables and risks that
central bankers have to contend with.

Fortunately, for us, we can keep it simple by following what 2-year bonds
are doing. In the past, this has been a quick and easy guide to where interest
rates should be heading into the future. I will be watching what happens to
these bonds to see if there are any major changes as time goes on.

While the yield on 2-year U.S. and Canadian government bonds peaked on
June 14th, the chart below from WSJ shows that the S&P 500 bottomed on June
17th. This shows how important interest rates expectations are for stocks at this
time.

While the first half of 2022 was the worst first six months of the year for U.S.
stocks since the early 1970’s, July had the best performance since November
2020. The S&P 500 rose 9.1% in July and is now down 14.2% from the high.
Inflation may be yesterday’s battle. The main concern of investors today seems to
be the risk of an economic recession. The “goal posts” shift quickly.

Statistics indicate that institutional investor’s exposure to equities is already
low. This supports what the long-term oscillators and many other indicators have
been showing us. It seems like the selling pressure has peaked. Stock prices have
recovered from the lows but some sort of catalyst is required for investors to see
the glass as half full instead of half empty. In the meantime, patience is required.
Thank you for your trust and confidence as we navigate uncharted waters!

 

SAR Update

 

After a relatively quiet first half of 2022, with 27 callouts, my Kent Harrison
SAR team responded to 10 calls in July, bringing the total to 37 calls compared to
44 last year this time. The year 2021 was an all-time record for tasks that we
responded to. The calls last month included 2 body recoveries, 2 medical rescues
and several searches.

While I have included many photos of beautiful water scenes from SAR calls, a
large number of our calls have us driving on dusty or dirty, rough gravel roads for
many kilometers. This is a photo of a recent call where the team responded to
rescue an injured dirt bike rider. Sometimes we are the only first responders who
can help people when they get into trouble in the backcountry. It always feels
satisfying to help people out when they need it the most. It is also enjoyable to be
together with other energetic like-minded men and women who know the
outdoors well, have many skills and are very nice people.

To reduce having problems, always think of what could go wrong and then
take measures to avoid it. Be safe out there and have a great weekend my friend!