The Folly of Forecasting Using Forward Curves

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1 SEP The Folly of Forecasting Using Forward Curves Patrick S. Kaser, CFA» In an environment full of uncertainty, investors seem to be relying more on forward expectations indicators to evaluate future conditions. An examination of two of these curves seems to indicate that forward curves drive a false sense of confidence and little else. It may be that market-based forecasts are just as bad as most other forecasts. The forward curve in oil prices is used as a basis for the future "range" of prices. There are two giant problems with this curve for starters: one is its historical accuracy, one is conceptual. First, the history shows that the futures curve failed miserably in forecasting the decline from $100+ to sub-$30, and also failed to forecast this year's bounce. It appears that participants in the curve simply anchor to the current price of oil plus the most recent directional trend when determining future prices. Second, major oil futures market participants all acknowledge that the liquidity and volume in future periods are very thin, and that even one reasonably sized participant entering the market can impact the future price expectations on the curve. If market participants know that future prices implied by the curve are likely to not be indicative, why are those prices still used as a reference point? The argument has been that "we've got nothing better." But in fact we do. The marginal cost of new production should be the long-term equilibrium price, and supply/demand dynamics should drive shortand medium-term prices. The collapse in oil prices, combined with the visible supply and demand responses, have now provided much evidence as to the likely medium-term price levels. We believe that the curve is underestimating likely prices over the next 3-12 months. Chart 1 and Chart 2 illustrate how the forward curve has historically been inaccurate as an indicator, both in the magnitude and direction of price changes!

2 See below to watch my video on how behavioral biases affect forecasting. With oil, we at least have physical production and supply/demand data albeit imperfect. Indeed, as Chart 3 shows, the

3 futures contract price generally tracks the spot price, which an R-squared of With future interest rates, we have the market as a weighing machine. While much could be written, I'd like to focus on one aspect: market expectations of a Federal Reserve (Fed) hike. Chart 4 shows how the implied probability of a December Fed hike has changed considerably over time:

4 These expectations are all over the place! Odds of a December 2016 hike bounce around considerably in response to data releases. As seen in the chart above, odds in December 2015 for a hike one year later were at 90%, and dropped to around 10% just two months later. If odds of a specific hike can move that quickly, and if odds of a hike in a given year can go from high to close to zero very quickly, then recover somewhat, the market is telling us that it has NO IDEA what rates will do several months out. This is a prime example of an indicator that is useful very close in reflecting high confidence that consensus is right, which it usually is close to an event but essentially useless for long-term investors. Despite human tendencies to act otherwise, I believe we all know intellectually that long-term investing wins out over short-term trading and forecasting. Recognizing the weaknesses of market-based forecasts can help investors focus more on what matters over the long term. Time arbitrage is an investor s friend in most asset classes; a focus on something other than the immediate-term provides a competitive advantage. Groupthink is bad, especially at investment management firms. Brandywine Global therefore takes special care to ensure our corporate culture and investment processes support the articulation of diverse viewpoints. This blog is no different. The opinions expressed by our bloggers may sometimes challenge active positioning within one or more of our strategies. Each blogger represents one market view amongst many expressed at Brandywine Global. Although individual opinions will differ, our investment process and macro outlook will remain driven by a team approach.

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