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The Random Character of Interest Rates.

The Random Character of Interest Rates

Interest rates pervade American life. Much of the federal budget is devoted to paying interest on the now enormous federal debt. Because most Americans finance the purchase of their homes, interest rates impact the cost of owning a house. The early seeds of the S&L crisis were sown with the spike in rates during the late 1970s and early 1980s. While interest rates generally concern most Americans, they are a topic of fixation for mortgage professionals. Rates determine the value of loan pipelines, warehouses and portfolios. Rates also influence the value of servicing and the overall level of loan production.

As with any item that attracts so much attention, a vast army has sprung up to watch and forecast interest rates. The federal government has the Federal Reserve to watch and, purportedly, regulate rates. Economists and other sages employ an array of forecasting techniques. Some subscribe to the fundamental approach and anticipate every Commerce Department release and revision. Still others rely on technical charts which encompass everything from moving averages to sunspots. Despite the diversity of forecasting tools, most people hold the following beliefs: * Interest rates are predictable. * Long-term rates are a direct function of inflation. * The yield curve is normally positively sloped. * Changes in interest rates reflect changing expectations.

Joseph E. Murphy, Jr. blasts these beliefs in his new book, The Random Character of Interest Rates. Most analyses of interest rates begin with a theory. Research is then undertaken to prove or disprove the theory. Murphy uses a different approach by taking an empirical look at the data. He observes and analyzes interest rate and bond yield fluctuations without any preconceived theory. Murphy draws some startling conclusions.

Interest rates are random - Murphy demonstrates that interest rate series move randomly rather than follow a predictable pattern. Their distribution is approximately lognormal with an upward move in rates as likely as a downward move. Further, past changes in rates give no indication of the future direction or magnitude of rates. Though small changes in rates are much more likely than moderate changes, extreme changes up and down appear more likely than would typically be expected with a normal distribution.

Many mortgage bankers attempt to achieve marketing gains from pipeline hedging activities by adjusting coverage levels to reflect their future interest rate expectations. Some only want to "earn back" price subsidies. By following this tactic, they gamble their company's future financial health on a random event.

Tendency of rates to move together - In the same historical period, rates for different maturities appear to move together. When yields rise for one maturity, yields tend to rise across all maturities. This "co-movement" accounts for most of the variability in rates rather than periodicity. Stated differently, rate changes in one period have little to do with the rates in other periods. Just because rates are declining, it does not mean rates will rise in the future.

Yield curve slope is random - Despite the widely held premise that the yield curve should normally possess a positive slope, Murphy demonstrates that its slope varies in a random fashion. A negatively sloped curve is as likely to occur as a positively sloped curve. However, the yield curve does have a distinct tendency towards smoothness. Although rates move together, short rates are more volatile. Thus, changes in slope are impacted more by changes in short-term rates than by the longer maturities.

For mortgage bankers, this means they cannot consistently depend upon earning an interest spread in their loan warehouse. For thrifts, it suggests a re-examination of their slavish devotion to ARMs.

Interest rates and inflation - Though the "rates equal inflation plus required return" theory holds almost universal appeal, the data analyzed by Murphy fails to support it. The ratio of short rates-to-inflation is a random walk for both U.S. data during 1950 through 1986 and for British data from 1750 to 1961. Interestingly, U.S. inflation data (1950-1986 CPI) does not appear to be random and instead exhibits an upward bias.

The mortgage industry celebrates those individuals who successfully bet on the direction of interest rates. At the same time, carcasses of companies that bet the wrong way on rates litter the industry landscape. After reading The Random Character of Interest Rates, those who have successfully "called the market" by betting on the direction of interest rates will be regarded as recklessly lucky rather than courageously smart. Murphy's book is must reading for anyone involved in mortgage lending. Those outside of the market with an "interest" in rates might also enjoy this book.
COPYRIGHT 1990 Mortgage Bankers Association of America
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Copyright 1990 Gale, Cengage Learning. All rights reserved.

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Author:McMurray, John P.
Publication:Mortgage Banking
Article Type:Book Review
Date:Nov 1, 1990
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