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Forward Curve Back Testing

Our last blog, NEV Does Not Equal NII, drew questions from some of our readers. Specifically, some questioned our comment about a forward curve’s inability to predict interest rates. This is fair, since some in the industry seem to treat it as a foregone conclusion that a forward curve will come true.

We hear a lot about back testing so let’s back test a forward curve. The table below looks at the 3-month LIBOR forward curve on the last day of October each year going back to 2007 for its “prediction” of where the 3-month LIBOR rate would be on October 31, 2014. The numbers have changed a little bit since then, but the message remains clear: a forward curve has not proven to be a good predictor of interest rates.

Back testing a 3 month LIBOR forward curve

For example, the forward curve as of October 31, 2007, “predicted” that, as of October 31, 2014, the 3-month LIBOR would be 5.37%. As of October 31, 2013, the forward curve was indicating the 3-month LIBOR to be 40 bps on October 31, 2014. The actual rate as of October 31, 2014, was about 23 bps.

Does your IRR process use a forward curve to predict rates?

Baseball legend Yogi Berra is credited with saying “It’s tough to make predictions, especially about the future.” We couldn’t agree more! Predicting rates can be good as part of the budgeting process but, when it comes to risk simulations, history has taught us that a forward curve is poor predictor of future rates. If your IRR process assumes the base rate environment will follow a forward curve, you could be missing risk. Understanding the risk of rates staying flat or not following a forward curve are lessons that should not be ignored. For this reason, we run IRR analyses that analyze potential earnings against the backdrop of all the interest rate environments including all of the yield curve twists that have happened in the last 60+ years.

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NEV Does Not Equal NII

Some in the industry say that net economic value (NEV) is an indicator of future earnings. Let’s test this out by modeling a credit union taking $30 million of funds that are currently sitting in overnights earning 0.25% and investing them in mortgage-backed securities earning 1.75%. Even without a model, we know that net interest income (NII) will increase; however, as we model the scenario, we will look at both the earnings and the NEV to see how they have changed from the base case.

The income simulation results below show that the credit union will be poised for higher earnings if it purchases the MBS and will increase its interest rate risk in a rising rate environment.

Income simulation for purchasing MBS

If NEV is an indicator of future earnings then one would likewise expect to see an increase in NEV in the current rate environment.  NEV results are shown below:

NEV unchanged by MBS purchase

Notice that the current NEV is unchanged. The credit union would be poised for higher earnings in the current environment if it purchased the MBS, so why didn’t the NEV increase?

Funds sitting in overnights are at par and, on the day the MBS is purchased, its purchase price is its value. In other words, $30 million sitting in overnights is worth $30 million and $30 million of MBS is worth $30 million. Therefore, the current NEV will not change.

The theory that the NEV will represent the future earnings is hard to defend and it misses key aspects of decision-making.

Some have tried to defend this concept by saying that the forward curve will predict future rates; the problem is that it has never done this consistently and has not done this at all over the last decade. If the forward curve were to accurately predict the future, the theory would indicate that the earnings of the overnights will equal the earnings of the MBS in the base rate environment. If decision-makers played this concept out, it would tell you that over time there is no reason not to have all of the credit union assets in overnights. Such a strategy doesn’t make sense.

From a business perspective, understanding the timing of earnings is one of the key questions to answer for decision-making. NEV does not help decision-makers see the timing of the earnings, nor does it answer many of the other key business questions (for more on key business questions, please refer to our c. notes titled Comparison of Interest Rate Risk Methodologies).