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

On that basis, the Frontier model offers a complimentary alternative to the Shevlin model outlined previously. Recall that the Shevlin model uses real US economic growth (GDP) and inflation (CPI) as inputs.

Note that I’m making certain assumptions about how to process the three variables for the Frontier model – assumptions that almost certainly differ from Frontier’s number crunching. Accordingly, the results are inspired by Frontier’s research note but should not be considered a flawless replication of the firm’s estimates.

Coding the results in R produces the following history:

The model has a rough time with the surge in volatility in interest rates in the late-1970s and early 1980s, but the estimates become more reliable as the years unfold. Presumably this is partly due to accumulation of more data history that informs the modeling. A calmer, trending market in recent years doesn’t hurt. Note that the current estimate suggests that the 10-year rate is about right, which implies that the recent rise in this Treasury yield has peaked. By contrast, the Shevlin model offered more scope for a higher yield in the near term.

Meantime, the history of the Frontier model’s residuals certainly indicate that the estimates have improved through time.

The results imply that the Frontier model excels when rates are trending. By contrast, the Shevlin model appears to be somewhat more useful for navigating turning points in rates, although these insights are probably marginal at best.

In any case, each model tackles the challenge of estimating fair value for the 10-year with a different set of assumptions using different data sets. On both fronts, the assumptions are reasonable. But like every model, some degree of noise intervenes. The goal is to aggregate different models with different types of flaws in the pursuit of estimates that more reliable — less noise, more signal — than available in any one model.

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Disclosures: None.

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