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?

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.

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).

For professional investors only

This document is issued by Lombard Odier Asset Management (Europe) Limited, authorised and regulated by the Financial Conduct Authority (the “FCA”), and entered on the FCA register with registration number 515393. This document is approved at the date of publication.

Lombard Odier Investment Managers (“LOIM”) is a trade name.

This document is provided for information purposes only and does not constitute an offer or a recommendation to purchase or sell any security or service. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful. This material does not contain personalized recommendations or advice and is not intended to substitute any professional advice on investment in financial products. Before entering into any transaction, an investor should consider carefully the suitability of a transaction to his/her particular circumstances and, where necessary, obtain independent professional advice in respect of risks, as well as any legal, regulatory, credit, tax, and accounting consequences. This document is the property of LOIM and is addressed to its recipient exclusively for their personal use. It may not be reproduced (in whole or in part), transmitted, modified, or used for any other purpose without the prior written permission of LOIM. This material contains the opinions of LOIM, as at the date of issue.

UK regulation for the protection of retail clients in the UK and the compensation available under the UK Financial Services Compensation scheme does not apply in respect of any investment or services provided by an overseas person. A summary of investor rights and information on the integration of sustainability risks are available at: https://am.lombardodier.com/home/asset-management-regulatory-disc.html.

Neither this document nor any copy thereof may be sent, taken into, or distributed in the United States of America, any of its territories or possessions or areas subject to its jurisdiction, or to or for the benefit of a United States Person. For this purpose, the term "United States Person" shall mean any citizen, national or resident of the United States of America, partnership organized or existing in any state, territory or possession of the United States of America, a corporation organized under the laws of the United States or of any state, territory or possession thereof, or any estate or trust that is subject to United States Federal income tax regardless of the source of its income.

Source of the figures: Unless otherwise stated, figures are prepared by LOIM.

Although certain information has been obtained from public sources believed to be reliable, without independent verification, we cannot guarantee its accuracy or the completeness of all information available from public sources.

Views and opinions expressed are for informational purposes only and do not constitute a recommendation by LOIM to buy, sell or hold any security. Views and opinions are current as of the date of this presentation and may be subject to change. They should not be construed as investment advice.

No part of this material may be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorised agent of the recipient, without Lombard Odier Asset Management (Europe) Limited prior consent. In the United Kingdom, this material is a marketing material and has been approved by Lombard Odier Asset Management (Europe) Limited which is authorized and regulated by the FCA. ©2024 Lombard Odier IM. All rights reserved.