Don’t expect rates volatility to decline overnight

The volatility in interest rates has surged over the past two years as central banks have fought this long-lasting increase in inflation. In this weekly edition of Simply put, we explain how this risk evolution has significantly reshaped our asset allocation.

 

Need to know: Over the past two years, the volatility in interest rates has amplified to an extent unseen in a more than a decade The demand for hedging as measured by the MOVE Index is one factor that should keep rates volatility higher Another is that with a higher level of rates has come a higher volatility of rates. These are reasons to be cautious with duration, in our view

 

Is higher rates volatility here to stay?

When implementing a risk-based investment approach, an abnormal escalation of risk should lead to a reduction of exposure to the corresponding risk premia. Today, interest-rate movements are one such risk, and investors will be asking: how long could this higher rates volatility persist? 

There are two ways of looking at it. First, hedging demand shows that rates volatility should not be expected to come down just yet. Second, rates volatility is historically a function of the level of rates: when interest rates are low, there is generally less volatility, whereas higher interest rates tend to be associated with increased volatility, which is the case today. 

Consequently, we believe that a lower allocation to bonds as well as a long-rates volatility exposure continues to make sense today. 
 

Hedging demand means higher rates volatility

The last couple of years have been characterised by rising inflation, which has led to tight monetary policies from central banks. Due to these movements, the yield on 10-year Treasuries recently surged to 5%, a level last seen in 2007-2008. 

The MOVE Index, often referred to as the bond market's ‘fear gauge’, has recently surged to its highest point since May as uncertainty about the future of interest rates and monetary policy remain high. Historically, when the MOVE rises, so does the realised volatility of rates. Both the MOVE and volatility of 10-year US Treasury yields have been rising side by side over the past two years, reaching levels comparable to those of 2007 (see figure 1). 

What does this mean? Given this relationship and the rising risks attached to rates volatility, investors may be seeking hedges against further yield increases and, as a consequence, yield volatility progresses. Therefore, given this demand for hedging, investors should not expect a decline in rates volatility soon. But this is not the only factor that speaks to a continuation of higher rates volatility. 

 

FIG 1. Moving together: the volatility of US Treasury 10-year yields and the MOVE Index

Source: Bloomberg, LOIM at October 2023.

 

Higher rates, higher volatility?

Another factor is the relationship between rates volatility and the extent to which US 10-year yields deviate from their average. 

In finance, big numbers usually mean bigger levels of volatility. Figure 2 compares rates volatility as a function of the level of rates, which we compute as the absolute 10-year rates in deviation from their past two-year average. The broad impression we get from that chart is that the larger the deviation of 10-year rates from their past two-year average, the higher the volatility. In simple terms, rates volatility shows a positive historical correlation with the level of rates. 

Given that actual 10-year US rates are hovering around 5% (see the red point in figure 2), higher volatility is probably here to stay. This is yet another argument in favour of remaining cautious with regards to bonds while maintaining exposure to rates-volatility strategies. 

While some investors argue that higher risk may correspond to (contrarian) entry points, our view is that an asset’s higher volatility reflects a higher uncertainty of the respective asset’s terminal value over a given horizon. It is one indicator among others that drives our asset allocation.
 

FIG 2. The volatility of US 10-year rates as a function of rates deviation from their trend

Source: LOIM, Bloomberg at October 2023.  

 

Simply put, growing demand for hedging and a higher level of rates could lead to an enduring environment of greater rates volatility.

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Nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises designed to track the recent progression of macroeconomic factors driving the markets.

• Growth: our indicator declined over the week, essentially as US newsflow showed macro deterioration
• Inflation: our indicator remained stable over the week, continuing to signal positive inflation surprises
• Monetary policy surprises: should remain a neutral factor to markets in the coming weeks

 

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)

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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