Interest Rate Forecasting
There are a variety of economic indicators used by the Federal Reserve, Wall Street
bond traders and institutional investors to forecast the direction of interest
rates. Some indicators are released by the Federal government; others are released
by private research firms and trade associations.
Residential mortgages, US Treasury securities, municipal and corporate bonds are
part of what is termed the “long term debt market” known as the “Capital Markets.”
There are many variables which influence the rates on long-term debt instruments.
An understanding of key economic indicators can provide clues to the future direction
of interest rates.
*Key economic indicators are listed below in general order.
This is the Federal Reserve’s analysis of the economy and an explanation as to
why they do what they do. This is published before each meeting of the FOMC and
gives some insight into their intentions.
The gross domestic product (GDP) is considered by many
to be the most important economic indicator published. Providing the broadest
measure of economic activity, the GDP is considered the nation’s report card.
The four major components of the GDP are: consumption,
investment, government purchases, and net reports.
Consumption spending represents about 56% of the GDP and
is divided into three categories: durable goods (items expected to last more than
three years), non durable goods (food and clothing), and services.
Investment spending accounts for about 14% of the GDP
and covers three categories: nonresidential (spending on plants and equipment),
residential (single-family and multi-family homes), and the change in business
Government spending represents about 17% of the GDP, covering
spending on defense, roads, schools, etc.
Net exports account for the balance or about 13% of the
GDP. Imports deduct from GDP and exports add to the figure. In recent years, the
U.S. has consistently experienced net imports, with imports exceeding exports.
The economy’s average sustainable growth rate has historically
been between 2.5% and 3.0%. Rapid economic expansion, growth, in excess of the
average sustainable rate, is generally short-lived, as it can lead to inflation
and, in turn, cause the Federal Reserve to tighten monetary policy in order to
slow growth. An economic downturn, or negative growth, is known as a recession.
During a recession, the Fed may lower interest rates to stimulate the economy
and increase the growth rate.
Bad news is good news for the bond market. A weak GDP
is received favorably by bond investors; a strong report causes concern the Fed
might need to intervene and raise interest rates (a negative for the fixed income
The consumer price index (CPI) in considered, by most economists to be the most
important measure of inflation. It compares prices for a fixed-list of goods and
services to a fixed period of time.
The consumer price index (CPI) in considered, by most
economists to be the most important measure of inflation. It compares prices for
a fixed-list of goods and services to a fixed period of time.
The CPI categories and respective weightings are:
- Housing 42%
- Food 18%
- Transportation 17%
- Medical Care 6%
- Apparel 6%
- Entertainment 4%
- Other 7%
Unlike other measures of inflation, which only cover domestically-produced
goods, the CPI covers imported goods, which are becoming increasingly important
to the US economy.
Analysts focus on the “core” CPI, which excludes the volatile
food and energy sectors. The core index is considered a more accurate measure
of the underlying rate of inflation.
The bond market can be extremely sensitive to changes
in the CPI which exceed expectations. Example: a higher-than-expected CPI can
cause bond prices to fall and yields to rise. Likewise, a lower-than-expected
figure is bullish for the market, causing the bonds to gain and yields to fall.
The producer price index (PPI) is a monthly indicator of inflation. It is a measure
of wholesale prices at the producer level for consumer goods and capital equipment.
Unlike the CPI, it does not included services.
The PPI categories and respective weightings are:
- Finished Consumer Goods 40%
- Food 26%
- Capital Equipment 25%
- Energy 9%
Except for the GDP, the government’s employment report is the most significant
economic indicator reported. It provides information on employment, the average
workweek, hourly earnings, and the unemployment rate.
The data covers the following major categories:
- Transportation and Public Utilities
- Wholesale Trade
- Retail Trade
- Finance, Insurance, and Real Estate
Jobless claims are US Labor Department reports of initial state jobless benefit
claims, seasonally adjusted. They give an indication of potential “wage inflation”
when they remain low.
The housing industry accounts for approximately 5% of the overall economy. Housing
starts is important because it is a leading indicator. Sustained declines in housing
starts slow the economy and can push it into a recession. Likewise, increases
in housing activity triggers economic growth.
Building permit data is released at the same time as housing
starts. Permit activity provides insight into housing and overall economic activity
in upcoming months. It is so important that it is included in the index of leading
Housing activity is directly impacted by mortgage rates.
Higher interest rates increase housing costs and reduce the number of qualified
borrowers, thus, a decline in home sales and drop-off in starts. Conversely, lower
interest rates increases housing affordability and spurs homes sales and housing
Housing data can have a significant impact on the bond
market. A stronger-than-expected report is viewed negatively, suggesting strong
growth and possible inflation. Housing data can have a significant impact on the
bond market. A weak report has the opposite effect on the market.
The National Association of Purchasing Managers (NAPM) index is based on a survey
of over 250 companies, twenty-one different industries, covering all 50 states.
The survey covers the following six areas:
- Commodity Prices
- Vendor Performance
Participants are asked to evaluate their position in each
of these categories as “up,” “down,” or “unchanged.” The calculated index is then
adjusted for seasonal changes.
The bond market views a strong number as negative and
a weak report as bullish or positive.
This report contains valuable information about consumer spending the consumption
part of the gross domestic product (GDP). Consumption spending accounts for more
than one- half of GNP.
Retail sales data represents merchandise sold for cash
or credit by retailers. Durable goods, such as autos, make up about 35% of the
figure. The balance consists of non-durables, like gasoline, restaurants, and
There are several drawbacks to the report. The data covers
purchases of goods only, not services. Services are becoming a major factor in
our “new” economy.
The bond market reacts negatively to a strong report.
A leading indicator of manufacturing activity. Increases in orders generally leads
to increases in production. Drops in orders are followed by a build-up of inventories
and, eventually, a decline in production. Economists use durable goods data to
forecast changes in manufacturing.
Durable Goods are hard to predict. A strong report is
bad news for the bond market, causing the bond to slump. Likewise, a weak report
is viewed positively by investors.
This is a composite index of economic variables that generally lead changes in
overall economic activity. This index is followed as a forecasting measure of
broader indicators of growth such as payroll employment and GDP. It is also followed
as an early indicator of future inflation. This is not viewed as an important
release because it is a rehash of previously released data.
This report measures the physical volume of output of the nation’s manufacturing
sector, including factories, mines, and utilities. Goods-producing industries
account for about 45% of the economy. The balance, the service sector and construction
industry, account for the remaining 55%.