Estimating Fair Value For The 10-Year Treasury Yield, Part II

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Earlier this month, I reviewed a model that estimates a theoretical level for the world’s most-important interest rate: the 10-year Treasury yield. In today’s follow-up, let’s consider a second model for additional context.

The goal in this series is to select several models with an eye on combining the estimates. A long line of literature demonstrates, rather convincingly, that one of the most (perhaps the most) reliable methodology for improving results with forecasting and estimating is drawing on insights from several modeling applications.

The power of combination forecasts assumes that the models are independent and in some sense complimentary. Taking the average of ten models with essentially the same methodology would be pointless. With that in mind, let’s add what we’ll call the Frontier model to the mix.

The idea for this approach was outlined in 2018 in a research note (“Frontier’s Quantitative ‘Fair Value’ Bond Models”) from Frontier Advisors. The paper outlines a parsimonious model with three inputs: 1) US unemployment gap (difference between the unemployment rate and CBO’s estimate of the non-accelerating inflation rate of unemployment); 2) volatility of 10-year yield; and 3) momentum of 10-year Treasury yield.

The author explains that “we considered using market derived measures of inflation expectations but, due to their shorter history (around a decade once sufficiently liquid), decided against this.”

The correlation of the unemployment gap with nominal growth, which itself contains an inflation component, does provide us with some comfort. As for the other two variables, their inclusion captures risk on/risk off behaviour and investor flows. During periods of market stress, realized volatility tends to pick up rapidly, with yields compressing as investors seek shelter in the UST market. Momentum likely picks up investor flows and other transitory factors the market focuses on from time to time.

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Disclosures: None.

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