Bond Markets: Fasten Your Seatbelts, Possible Turbulence Ahead
|August 21, 2014||Filled under Featured Article|
Iraqi Government -
It is a bit of a strange juxtaposition that, despite the many recent alarming occurrences of geopolitical tensions around the world including Russian troops amassing on Ukraine’s border, seemingly perpetual fighting in Gaza, and a besieged Iraqi government on the verge of collapse, bond markets have perhaps never been more complacent. During the ‘taper tantrum’ last summer, the 10-year Treasury yield exploded higher as the market reacted to indications from the Fed that its quantitative easing (QE) program had an expiry date. Over the past eight months, however, as the tapering has actually been implemented, Treasuries have somewhat slowly but steadily drifted higher while the uncertainty priced into bond markets has plummeted.
Where yields and volatility are today, bond markets do not seem to be anticipating some key inflection points in monetary policy which are lining up on the horizon. As the Fed moves its focus from ending QE to increasing interest rates, bond markets may be in for a bumpy ride.
Volatility Collapse in Bond Markets
This year’s bond market rally has pushed yields lower, but still well off 2012 lows. The more interesting effect of the rally has been the collapse of bond market volatility. The uncertainty priced into US Treasury Bond futures, as measured by implied volatility, is now near 2007 lows. The Merrill Lynch MOVE Index reports the average implied volatility of options on Treasury futures contracts across the interest rate curve. The MOVE Index is currently hovering near all-time lows. Outside the US this phenomena is even more pronounced as volatility in German Bunds is now at 20 year lows as is volatility in Japanese JGBs. This reveals a striking truth, we are now at generational lows of volatility observed in fixed income markets.
When in Doubt, Blame it on the Fed
There are a variety of potential explanations for this collapse in volatility. Following the financial crisis, developed markets have been teetering on deflation. Even with the recent improvement in economic prospects in the US, inflation has remained subdued. Low inflation expectations provide room for policy rates to remain low and for long term expectations of rates to remain benign. The benign inflation outlook has helped put a lid on any large swings in bond price movement.
Furthermore, monetary policy communication has shifted in recent years. Following the financial crisis, a ‘low for long’ communication regime took place at the Fed. In that model the Fed moved away from a data-driven policy and instead committed to keep rates low for a substantial period of time regardless of data. This commitment from the Fed removed much of the uncertainty surrounding the potential path of interest rates, and thus led to lower rate volatility.
Also, the balance of supply and demand within bond markets has been heavily influenced by central bank balance sheet expansion over the past several years. The size of the Fed buying program has been immense and has dominated the net supply. For example, during 2013 the Fed purchased around 71% of net Treasury issuance. Additionally, the Fed uses highly sophisticated interest rate curve models to guide its buying program, which has reduced any ‘kinks’ in the interest rate curve. This again had the effect of creating a more static, well behaved interest rate curve, dampening any volatile price movement. The Fed is currently expected to end QE purchases in October and the effect on markets is hard to predict. However without a consistent large Fed bid for bonds, prices seem unlikely to remain as stable and static as they are currently.
Priced to Perfection
So what does this mean for bond investors? One of the most fundamental and wide-reaching implications is that the compensation that bond holders are receiving for taking interest rate risk is extraordinarily low. Currently (as of 8/18/2014) a Treasury investor can receive a yield of 2.39% for buying a 10 year Treasury bond.
Current inflation expectations are predicting an average inflation rate of around 2.18% over the next ten years (based on break-even inflation rates priced into the TIPS market). This provides investors with a margin of safety of just 21 bps for taking on inflation risk over the next 10 years. Another indicator for market frothiness is the difference in yield between Treasury bonds that are currently being issued by the US Treasury, versus Treasury bonds that have been issued. Recent data shows that this relationship is near the tights of 2007, i.e. investors are not being compensated very well for taking on any liquidity risk in bond markets.
So far this year, the collapse in volatility has generally been very good to long-only bond investors as high quality bond indices have posted attractive returns. However the low volatility has posed significant headwinds for many alternative strategies that are employed by hedge funds. Relative value trading, which involves going long and short different bonds on the yield curve in order to profit from dislocations, has been generally less attractive in recent years.
As volatility collapses, bond curves remain more static and dislocations in the curve are less likely to appear. Directional trading in FX markets, the large move in the Yen last year being the exception, has also been generally less fruitful as most currency pairs have remained within a tight trading range in the larger developed markets. Put another way, it’s hard to profit from trends in FX and fixed income when these markets have generally remained static.
Storm Clouds Ahead
As we approach the end of the year, there exists the strong potential that this trend of ever lower volatility in fixed income markets could reverse abruptly.
First, the Fed has pivoted their communication regime from ‘don’t worry we’ll keep rates low for a long time no matter what the data says’ to something more along the lines of ‘we’ll move rates based on what we see in the data.’ This is a subtle but important shift. Regardless of when rates do eventually move higher, economic data is inherently noisy. Measuring economic production, jobs added, unemployment, price changes, and so on, are all tasks that involve a healthy dose of measurement error. As economic data is released over time, the market may over-react to the noise pushing rates either too low or too high in the process. The price fluctuations will by definition mean higher volatility in fixed income markets.
Secondly, the market structure in bond markets has changed following the crisis. ‘Too big to fail’ was too much to bear, and regulatory changes following the crisis have fundamentally altered the risk appetite in investment banks. Inventory of bonds on investment bank balance sheets are over 80% lower today than they were in 2007. This means that the liquidity buffer that banks had provided to bond markets no longer exists to the extent it once did. In times of stress, bond markets are more likely to see more violent price moves as a result. We witnessed this last summer in many markets including municipal bonds, high yield, and emerging markets. When investor flows turn abruptly, sometimes there is no one left to buy bonds.
Finally, the Fed will eventually raise rates at some point. As they do, this will create uncertainty as to how much they will raise, how fast they will act, and when they will begin. All of this uncertainty will lead to some degree of volatility. Historically, interest rate volatility has also tended to be higher when rates are higher; as rates go up, so will market volatility.
Beware of Still Waters
Markets may appear tranquil today, but given the expected shifts in monetary policy over the next several months, this is likely to change. Current risk premiums priced in to bond markets are near all-time lows and this doesn’t leave investors with much margin for safety when the winds of change do pick up. In the recent calm induced by central bank buying and ever lower market volatility, long-only bond investors have reaped handsome rewards while relative value and macro hedge fund strategies have struggled to find opportunities. Looking forward, however, this is likely to reverse as market volatility picks up steam.
Related Iraqi Dinar Articles-