The Unknown Unknown

There are 2 types of things that get used to make predictions in finance: The known unknown, and the unknown unknown. A known unknown would be something like GDP, employment reports, inflation numbers etc. We all know when the inflation report will come out, but we aren’t sure what it will be. We know it could impact interest rates, but we don’t know up, down or sideways.

However, in finance, like in everything else, there is always a component of the formula that is based on things that no one can ever know, and therefore cannot compute into their predictions. Last night was a great example. I certainly did not have an attempted assassination of a Presidential candidate on my 2024 bingo card. While the news is a buzz of what this means, lets look at the financial impact.

First of all, lets put politics aside. I don’t care if you like the Donald, or despise the Donald. As I have said many times before, it isn’t what it is, but rather what it represents. The assassination of any political figure puts our system of law and order at risk. Since much of finance is based on the rule of law, if we can’t have law and order, then financial markets cease to operate. I don’t think how many people realize just how close we came to complete pandemonium last last night – in society and financial markets. Had the attempted assassination ended up being an actual assassination, bond yields would have dropped around 25 to 50 bps by Monday morning open. Instead we are sitting here at 8:00 pm EST and the US 10 year yield is down 1 basis point.

Now I am certainly not suggesting we assassinate political figures to get interest rates down, but that is just how sensitive interest rates are. Lets explore why.

There was an old saying I remember well from my younger days “My word is my bond”. That was back in the time when someone’s word actually meant something of course. Bonds are something that convey security, stability, and are often used as a source of preservation. Bonds tend to act like the police officers of the investment world – when you are scared and need help, you buy a bond. Things like an assassination scare people to get out of higher risk things like stocks, and run for bonds. The more people that want to buy bonds, the lower the yield goes as the price goes up. Bad news is good news for bond investors, and vice versa. When the world is crazy, and risk is more than just a four letter word, a lot of people like to try and control what they can, and a bond helps them to do that.

There are a lot of things that go into yields in todays market. Foreign exchange, interest rate expectations, economic growth, the list is endless. Economists and forecasters can use these items to help shape their opinion on where they think bond yields – and in turn mortgage rates will go over the coming weeks, months and years. All of the known unknowns can be ripped apart piece by piece and models built to show different outcomes with different numbers in each piece or ingredient. For example, many forecasters have models that shows what they expect to happen if inflation went up by .50%, went down by .50% or stayed flat. This is relatively easy to model. Same goes for jobs. If we create 10K jobs next month, 50K jobs next month, or lose 100K jobs next month. The data can be manipulated under various scenarios to show different outcomes. Then the question for the person putting out the report is which of the scenarios are most likely to happen, and viola, you have a forecast or prediction.

However, when you start throwing things like assassination attempts, wars, bombings, and the like into the models, they aren’t all that predictable. This is imply because the data behind those events are so hard to come by, so you can not build a reliable model and get a confident prediction. These things can often be called black sheep because they happen so rarely. COVID was a great example of a black sheep, and something where the models were all wrong simply because we had no data to shows what happens when the entire world shuts down. All of the data leading up to COVID was based on things like employment, inflation, etc. Once we started shutting down it was nothing more than a guessing game, because there was no way to model the outcome with past data. We all knew interest rates would fall ( they always fall when shit hits the fan ), but other than that, no one really knew. Would they fall a lot, a little, stay down, go negative? No only could really say with any confidence. Hell, even Tiff Macklem got it wrong in his infamous speech on July 20, 2020 of “interest rates will remain low for long. If the guy in charge of monetary policy can’t give a reliable prediction, who really can?

As the world becomes a more volatile place, black sheep are likely to become more common, which in turn makes predictions less reliable. Interest and exchange rates are one of the first things to move on news – good or bad, and as such, expect to see more volatility over the coming weeks, months and years. If we take a look the Canada 5 year bond yield right now, it is only slightly lower than when the BOC cut rates on June 5th. Up until this week it had been higher. It has been range bound, and that has been what most people had predicted. All they had to do was put the employment numbers, inflation data, GDP readings etc. into the model blender and report the finished prediction. So far most have been accurate.

As we go into a world where there are more unknown unknowns, these predictions will become less accurate. That is through no fault of the author, the economists, or bond market experts, it is simply a reality of the times we live in. I say all that so that you have realistic expectations going into the next 6 to 8 months. A lot of people will be wrong on their predictions – especially on interest rates. Never rely solely on 1 persons report, 1 persons prediction, or 1 persons social media account. Get a lot of perspective, and always look for what can go wrong. Always question where the risk lies in your scenario. If a client is convinced they want a variable, see where the blind spots could be. Could rates flatline here and Prime not go down? Could rates actually go up? If a client wants a 3 year fixed, looks at the risks that the client can’t see. Maybe the rate is better, but what is the renewal in 3 years time looking like? People have a lot of blind spots around finance, and you need to be their blind spot mirror and see what they cannot. Case in point – today I got a call from a client who wanted to lock in their variable because of last nights event. Um, okay, but events like last night create uncertainty, and that uncertainty generally drives rates down not up. The client was acting on pure emotion, and not thinking clearly, so it is my job to help walk them through it. The reason they are on a variable was valid when we set the mortgage up, and nothing has changed, so from a fact based perspective, it still made sense to stay variable. Their emotions surrounding a 1 time ( hopefully ) event shouldn’t change their financial life.

Be your clients blind spot mirror, look out for the bumps in the road they might not see, and always make sure you are getting multiple ideas to form your opinion. Simply watching some Tik Toks is not enough. Read the experts, subscribe to some great blogs, and follow finance experts who have no vested interest in a specific outcome.

And just for the hell of it, I will throw you a prediction:

I do not think rates will fall as much as everyone thinks. Looking at history, every politician that has been the target of an assassination has had their popularity soar. Markets of all kinds, bond, stock, currency, commodities will start to price in a Republican win in November for the US. This will lead to some volatility while markets adjust, but it will also probably leave rates higher than what a lot of people think. Yes, rates will come down a bit, and there will be a lot of chop, but I don’t think they will drop like you or your clients think they will.