Economists build complex models. Officials at the Federal Reserve use some of these models to forecast interest rates.
Among the most popular interest rate forecasting models is the Taylor Rule. First published in 1993, the Taylor Rule states the correct interest rate is determined by the rate of inflation of the level of slack in the economy.
This rule has done fairly well forecasting the direction of the trend in rates. This is shown in the chart below where the forecasted rate is shown as the blue line and the actual rate is the red line.
Traders have little use for models like this. In order to generate profits, traders would need to know not only the direction of the trend but also whether the actual rate will overshoot or undershoot the target rate.
Traders have also created models to trade interest rates. Many of those models are complex, sometimes more complex than the Taylor rule and other econometric models.
Some models are relatively simple. Among the simplest was one Tom DeMark used in 1974 to surprise Alan Greenspan, then one of the leading economists in the world and later the Chairman of the Federal Reserve.
While working at an investment consulting company in 1974, DeMark attended a presentation by Greenspan. To prepare for the meeting, DeMark reviewed a chart of interest rates in The Wall Street Journal. He applied a technique he developed called TD Lines. He shared his forecast with Greenspan. It was memorable because it contradicted the consensus forecast.
A short-term later, the target was hit. Greenspan questioned how he had made a forecast that basically ignored the economic data.
DeMark’s work was similar to trendlines, but very different. Usually, trend lines are arbitrary, and every analyst draws their own version of this indicator. Trendlines also aren’t generally used for price projections.
The rules for TD Lines are precise.
Unlike traditional trendlines, TD Lines focus on the right side of the chart.
What happened to the left of a chart is history and its relevance upon current price activity diminishes with time due to continuous changes in supply and demand. Because of that, DeMark focuses on the most recent price points to construct a trendline.
TD Lines are a graphic representation of supply and demand. They must be redefined and redrawn continuously as the relationship between supply and demand changes.
Supply Lines measure demand based on lower highs and reveal the upside potential when a qualified Breakout occurs.
To draw a Supply Line:
- Identify the two most recent Supply Points. A Supply Point is identified as an intrabar high that is preceded and succeeded by lower intrabar highs.
- Connect these points.
- When a new Supply Point forms, redraw the Line to connect the two most recent points
For a Demand Line, Demand Points based on intrabar lows are used. This technique can be used in any timeframe.
An example is shown below. Green lines are Supply Lines; red lines are Demand Lines; and blue lines show projections based on the lines.
Price targets are calculated based on extreme price movements above or below the Line. Breaks of the Line are qualified with additional rules.
What Greenspan learned that day in 1974 was that there tends to be a degree of symmetry in the market action. DeMark found a way to quantify and potentially profit from that tendency.