Year of the Black Swan
On the lunar calendar, this weekend marked the end of the Year of the Monkey. Looking back, however, perhaps it could have been called the Year of the Black Swan.
Consider all the very low probability events that confounded predictions, both financial and non-financial:
(a) The British pound started the year with less than a 5% chance of being at or below 1.2318, but that’s exactly where it ended.
(b) As the day dawned on both the Brexit referendum and the American presidential election, the winning side was given less than a 25% chance of victory by almost all forecasters.
(c) Half-way through the year, the US 10-year swap rate had less than an 8% chance of finishing the year at 2.335%, but it closed at that level on December 30th.
(d) Leicester City rose from third division ignominy, overcoming 5000 to 1 odds along the way, to capture the Premier League title against five clubs with 65 times the financial power.
(e) Perhaps most shockingly, the movie that tied the record for most Oscar nominations of all time, La La Land, is a musical!
Whenever we have a year like the last one, several key lessons emerge. The first is to be cautious when relying upon probabilistic forecasting approaches that do not hold themselves accountable. Analytic forecasting should constantly calibrate itself against reality to ensure that it is accurately depicting what takes place. 5% likelihood events happen from time to time, but if they happen half the time, then the models calling them 5% events are flawed.
Secondly, it’s vitally important to ask with every significant binary prediction event – if the very unlikely takes place, how prepared are we to weather it? Sound risk management will prepare for both eventualities, however unlikely, with a well-crafted plan that includes economic impact assessment and mitigation. The hedged slept the best on the night of the Brexit referendum.
We reflected on all that transpired last year as we put together our semi-annual market update webinar, which ended up being our most well-attended webinar ever. We talked about how interest rate forward curves perform against realized LIBOR, and discussed the Fed “dot plot,” which shows how each Fed member envisions the path of interest rates over the coming years. In addition, we talked about volatile currency markets, and some of the most important financially impactful areas to watch in the coming year, including US fiscal policy, austerity in Brazil, European elections, and the Chinese economic slowdown. If you’d like to watch the recording of our webinar, please follow this link to do so.