multi-asset
What is keeping rates volatility high?
Volatility in fixed income markets remains elevated while it has normalised almost everywhere else. In this weekly edition of Simply put, we ask why has bond volatility remained stubbornly high?
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Investor views diverge
Since 2022, we have seen increased volatility, especially in fixed income. Last year started with low and falling expectations for global growth and heightened fears of a recession, while this year sees us heading towards a ‘soft landing’ economic scenario, depending on inflation.
This context is causing investor views to diverge. When expectations regarding growth and inflation deviate in this manner, expectations around rates become unstable too, meaning bond volatility stays high. Over the past two years, bond volatility has remained elevated. With inflationary pressures seemingly waning, rates volatility should decline – and yet it remains the only volatility in our risk analysis that has not normalised today. If disinflation does not do the trick, what will?
We think the fact investors are divided is probably the missing link. Investors are still polarised between doom-sayers and perma-bulls, which could explain why bond volatility is high, as it shows a heightened level of tension between both types of investors. Do we need a stronger consensus to materially bring down rates volatility?
Improving volatility but not everywhere
The evolution of volatility in developed equities, bonds and commodities is shown in figure 1 for the period spanning 2019 to 2024. Notably, two distinct spikes in volatility are evident for all asset classes, the first occurring during the Covid-19 crisis and the second from 2022 onwards. By the end of 2023, the second peak of volatility had subsided for equities and commodities, with their respective numbers falling below median levels. However, this was not the case for bonds. Bond volatility remained extreme throughout 2023 and currently stands at around 4%, surpassing its median value of 3%. The volatility of bonds can be primarily attributed to factors such as inflation, the overall state of the economy, the outlook for Federal Reserve (Fed) policy, and ultimately investors’ perceptions, understanding and trust in these factors.
In 2022, as inflation rose to a four-decade high, the Federal-funds rate was raised at an unprecedented pace, and bond volatility leapt higher. Following the announcement of the Fed’s pivot in December 2023, we saw a decline in rates. Despite this decline, bond volatility remains relatively high compared to historical averages. With falling inflation, dovish monetary policy and relatively high growth, what else could explain how volatile bonds are?
Figure 1: Evolution of developed equities, bonds and commodities volatility indicators.
Source: Bloomberg, LOIM.
Markets are not the economy
This year has started off with positive data for equities, with gains reflecting stronger-than-expected earnings, rising employment data and the US ISM report, and a strong US economy. Bond holders, on the other hand, are in a much more complicated situation, as the Fed is not expected to cut rates in March, bringing us back to the ‘higher for longer’ period.
This mixture of factors is probably creating outsized uncertainty on the prospect for bonds. One way to measure this level of disagreement is by looking at how closely investors are aligned on future economic prospects. Our method of measuring disagreement is by computing the standard deviation across the three key AAII investor positioning surveys, showing investors ratings for bullish, bearish and neutral exposures. The larger the standard deviation and the larger the heterogeneity of opinions across investors, the greater the disagreement.
Figure 2 shows the volatility of bonds and compares it to that ’disagreement indicator’. Uncertainty in the market is currently high and looking at the evolution of this pair of series, periods of heightened investor disagreement tend to be associated with higher rate volatility levels. The current level of disagreement rate is around 90%, which is comparable to rates in 2022 and 2020. Hence, in order for bond volatility to subside, market participants could need to reach a consensus. The next section looks at investors’ disagreement measure in more detail.
Figure 2: Bond volatility and investor disagreement through 2020 - 2024
Source: Bloomberg, LOIM.
How do investor views relate to bond volatility?
To help us quantify, figure 3 shows the percentage of investors in disagreement and the respective average bonds volatility. As the proportion of disagreement increases, so does the realised volatility of bonds. For instance, when the disagreement indicator reaches 80%, bonds volatility averages more than 2.7%. Comparing this figure to the average volatility observed between 2001 and 2024 (of 2.4%), more than 2.7% is high. We apparently need views to better align for rates volatility to normalise for good, and to return to more typical exposure to duration risk. Ultimately, high(er) rates volatility may also contain an element of trust (or lack thereof) from investors with regards to inflation and growth being effectively under control.
Figure 3: Bond volatility as a function of disagreement among investors
Source: Bloomberg, LOIM.
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Simply put, rates volatility will remain higher until investors reach a consensus on the macro outlook. |
Nowcasting corner
The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises are designed to track the recent progression of macroeconomic factors driving the markets.
Our nowcasting indicators currently show:
- Growth perspectives have improved during the week, notably through US and European data
- Inflation pressures remain low but have increased across the US, the eurozone and China
- The current mounting dovishness across central banks was further confirmed this week as our monetary policy indicator declined across all three zones
World growth nowcaster: long-term (left) and recent evolution (right)
World inflation nowcaster: long-term (left) and recent evolution (right)
World monetary policy nowcaster: long-term (left) and recent evolution (right)
Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).
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