Rates Volatility And The Indoor Trampoline

Everywhere you look: cracks, risks, land mines, volatility.

And unlike June, July and August, recent tumult cannot be swept under the rug or otherwise written off by insisting that idiosyncratic flareups in far-flung locales like Turkey and Argentina aren’t systemic; or by claiming that emerging markets are resilient enough to weather the Fed tightening storm; or by leaning on the assumption that because the consequences of an all-out trade war would be so dire, even the most irrational of actors (i.e., Donald Trump) will ultimately deescalate.

Now, things that “matter” are moving. For example:

• Big-cap tech logged its worst month since 2008 in October and this week saw yet another “nightmare on the Nasdaq“.
• The epochal Growth-to-Value rotation that many thought would never come appears to be materializing to the detriment of a market that depends heavily on outperformance by crowded trades like FAANG and BAT.
• Equity hedge funds are under siege from the October malaise.
• Investment grade credit is front and center in investors’ minds as the great “BBB debate”, fallen angel risk and duration jitters prompt questions about where IG falls in the hierarchy of vulnerability.
• WTI logged its worst losing streak on record on the way to careening lower in the largest one-day plunge in more than three years as fundamental factors collided with the implosion of a long WTI/short nat gas bet and dealer hedging effects.
• Demand concerns have piled pressure on Apple and results from Nvidia and Applied Materials suggest the Semi cycle is turning.
• The synchronous global growth narrative has definitively morphed into a story about a “synchronized global slowdown“

And on and on.

Bloomberg underscored all of this in a piece out Friday appropriately entitled “‘Get Me Out’: Investors Sour on Market Strewn by Tape Bombs.” Here’s a quick excerpt that captures the gist of it:

When everything starts to go wrong at once, imaginations can run wild. Like now, when everywhere you look, something’s blowing up. In commodities, it’s the record plunge in oil. In equities, it’s six weeks of turbulence in the S&P 500. Debt markets have been rattled by the turmoil engulfing General Electric and PG&E. Bitcoin just plunged 13 percent. And Goldman Sachs, the storied investment bank, is having the worst week since 2016.

Amid the storm, there’s one place where volatility isn’t showing up: Rates.

“Risk remains elevated across all market sectors, showing up in every form, from geopolitical, sovereign, pseudo-systemic, as supply shocks, through trade wars, or as idiosyncratic pushing risk premia wider and creating vol spiking everywhere except in rates market, which remains uncharacteristically calm”, Deutsche Bank’s Aleksandar Kocic writes, in his latest note, dated Friday. “In that process, rates volatility remains decoupled from other measures of risk premia”, he adds.

Below are some visuals to underscore the point (left pane is just equity vol. in units of rates gamma, while the right pane is oil vol expressed the same way).

(Deutsche Bank)

A similar disconnect can be observed in rates vol. versus IG credit spreads and implied IG credit vol.

What accounts for the disconnect? Part of the answer is simple. To the extent the recent slide in stocks is a manifestation of the Fed restriking its put, rising equity volatility is attributable to the implicit withdrawal of convexity which is being recycled and redistributed as convexity supply to the long end of the curve. Meanwhile, the tightening of financial conditions occasioned by the equity selloff equates to a greater or lesser degree (depending on the depth of the drawdown) to a rate hike which, conceivably, could obviate the need for further hikes down the road. As Kocic reminds you, “a 15% decline in equities results in the same amount of tightening of financial conditions as one rate hike, which forwards continue to underprice anyway [so] in the context of the current debate between the Fed and the markets, stakes in rates remain relatively low compared to other sectors.”

But there’s more to it than that.

“Another reason behind low volatility in rates is the way the Fed has been conducting the policy unwind”, Kocic goes on to write, before describing the dynamics as follows:

In general, monetary policy is transmitted to rates market via an error correction mechanism which resides in the core of yield curve dynamics. The long-term target for policy rate is set by the long rates and the pace is a function of the curve slope. Policy gap is the spread between long and short rate. It is the road ahead for the short rate. The main concept that ties the curve shape to monetary policy is cointegration.

This discussion goes back to the “shrinking playground“. The policy gap (the “playground”) defines the scope for rates volatility. As Kocic is fond of putting it, “anything that can happen, happens inside that gap.”

That’s the context for what follows, or at least that’s the easiest way to frame it if you’re familiar with the “shrinking playground” characterization (if you’re not, the link above should help).

Picking up where the excerpted passage above leaves off, Kocic describes cointegration as follows (normally I would paraphrase this, but as you’ll see, the chances of something getting lost in translation are high, so I’ll use a direct quote instead):

Integrity of the curve is expressed by the common long-term agenda which all points on the curve share. Irrespective of what kind of environment we find ourselves in, the curve never falls apart. If temporary deviations from the long-term agenda show up, they are short lived — subsequent rate changes are such that they aim to restore the curve integrity. Thus, yield changes are correlated with departures of the curve from their common trends. This is the essence of the error correction dynamics inherent to cointegration of the curve.

Kocic goes on to express those error correction dynamics as an equation for the short rate which he then integrates to describe (mathematically) the interaction of the information embedded in the curve shape with the historical behavior of rates.

That’s a lot to wrap your head around, but the bottom line, Kocic notes, is that “the expected rates range is bounded by the policy gap” which in turn defines the limits “on options breakevens and, therefore, volatility.”

Again, this falls into place nicely if you take a few minutes to review some of the “shrinking playground” posts linked above or, if that’s too much to ask, just consider the following two visuals which plot the policy gap with rates vol.

(Deutsche Bank)

Obviously, it’s an oversimplification to say, as we did above, that the policy gap is the only thing that matters for vol. That is, if the gap disappears entirely, volatility isn’t going to just flatline altogether. “There is always residual uncertainty in rates determined by liquidity and other factors [so] volatility never collapses to zero”, Kocic notes.

Ok, now think about where the policy gap was when the current cycle started, versus previous cycles (as shown in the charts). Here’s Kocic doing the math based on the 2004 experience:

If policy gap is around 500bp, then, assuming the cycle lasts for about two years, the annualized maximum vol this gap allows is around 350bp (= 500bp/ sqrt(2)), which means a quarterly vol of about 180bp. Adding the zero-point vol of 40bp, this gives max 220bp of realized allowed by the 500bp policy gap (as shown in the figure).

This time around (i.e., in the current cycle), the gap was just 200bp to start, which means, using the same rough math, the maximum possible realized vol. is ~110bp. Kocic goes on to reiterate the annotations in the visuals (which are themselves a reiteration of points he’s made before). To wit:

Unlike previous tightening cycles when initially wide gap gradually tightened as the rate hikes progressed, in the current cycle we started with a tight gap and have closed in very quickly. With each subsequent hike, it appears as if the short rate is pushing the long rate from below. In this way, rate hikes continue without allowing volatility to take off.

This is a readily apparent effort on the part of the Fed to guard against the main tail risk – a disorderly unwind of the bond trade.

There are only two ways for rates vol. to materialize in a meaningful way. Bear steepening (presumably when the term premium finally stops being stubborn) or bull steepening (something causes the market to take some of the hikes out). As Kocic puts it, what’s needed for rates vol. to take off is “a higher ceiling” or a “lower floor”.

And with that, we’ll leave you with one last quote from Kocic followed by a video summary…

Behavior of rates volatility, when seen in the context of monetary policy, is akin to the problem of bouncing on a trampoline in a room with adjustable ceiling heights. Injuries occur when the amplitude of the trampoline jumps exceeds the ceiling height. These are the episodes when volatility violates policy bounds due to short convexity covering.