Over the past several months, we’ve spilled so much digital ink in these pages discussing suppressed rates volatility that I’m tired of hearing myself talk.
Not really. I mean, yes, we’ve talked a ton about rates vol., but no, I’m not tired of hearing myself talk. As regulars know, I never tire of hearing myself talk, which is a good thing for you, dear reader, because I am a veritable wellspring of entertainment.
Last Wednesday, we brought you some highlights from a lengthy SocGen note that sought to describe and otherwise analyze the sequencing of vol. spikes across different assets and the main factors linking cross-asset volatility.
Unsurprisingly, the bank found that the “temporal asynchronisation in regime changes across business cycles” usually manifests itself in equity volatility being “first out of the gate while rates volatility has been the laggard.”
2008 was obviously an exception and as we noted on Wednesday, the reason for that is intuitive/self-evident. “After all, the unfolding of the subprime crisis was the rates-driven event”, we noted, quoting Deutsche Bank’s Aleksandar Kocic.
Well, speaking of Kocic, he’s out with a new piece called “Everything is changing, but nothing is different” and in the first sentence, he notes that “despite abundant turbulence since early November, it is becoming rather unambiguous that appetite for interest rates volatility is disappearing.”
While it might seem somewhat odd or paradoxical that volatility legged lower at the very time when, to quote Kocic again, “things started to become interesting”, it’s not all that hard to explain if you take a step back and think about what the recent policy bent means in the context of constrained monetary policy and a macro backdrop where growth risks are proliferating. Here’s Kocic:
Despite years of accommodation, things don’t look great, but not very bad either. There does not appear to be any major economic imbalances or runaway inflation on the horizon that could trigger a dramatic economic downturn. Even if we are recession-bound, given stricter regulatory constraints and years of considerable deleveraging of the private sector, the recession is likely to be a shallow one without massive and/or very aggressive deleveraging. However, given the expansion of the public balance sheet and still relatively low rates, we are less prepared to combat recessions, even if they are shallow. This means that, in addition to rate cuts, the Fed would need to grow its balance sheet again, which takes us back to financial repression, low yields and range bound rates, which implies another wave of protracted supply of convexity to rates and transfer of uncertainty from rates to other markets. With that outlook, it is difficult to build a case for owning rates volatility over any horizon.
All of that said, Kocic notes that there is one exception: reds. “Although declining across the board, most volatility remains concentrated in the red sector of the curve”, he writes, adding that “while it appears that everything is gradually falling apart, or is at least on shaky grounds, the curve seems to be normalizing.”
Regular readers will remember this discussion from last May and as noted, there’s a sense in which it represents a return to normality. If volatility resides primarily in reds, then things are as they “should” be, where that means new information is manifesting itself in a similar fashion as it did pre-crisis.
Here’s a near two-decade history of the ratio between realized vols. in the red sector and the 10Y (3M rolling):
Again, this goes back to the notion that if volatility starts to move outward, it suggests folks might be a bit unsure about the Fed’s quest or, more to the point, about how things will ultimately end up. If, on the other hand, we see a return to a scenario where volatility resides in reds, it could signal a rebuilding of trust. Here’s Kocic rehashing the point:
Prior to 2008 financial crisis, Red contracts on the Eurodollar curve used to be the most volatile rates sector. Typically, policy relevant horizon was set to be around two years. On the back of that, rate hikes become an optimal control problem. The Fed sets on its “journey” with the market making up its mind about where the terminal rates should be. This “anchors” Green contracts (2Y forwards) and stabilizes rates beyond the 2Y horizon. While the market remains confident about the success of the “journey”, it grants Fed an option to optimize rates path. As rate hikes occur at discrete time intervals, the very front end remains relatively inert, and with terminal points being already set, the most volatile sector falls somewhere in the area of 1Y forwards. The arrival of new information does not affect materially either the immediate Fed action or its final destination, but mostly the path along the way to terminal rate. Concentration of volatility in the Red contracts is an expression of market’s confidence regarding the success of Fed’s “journey”.
And so, with rates vol. declining everywhere with but a single exception (i.e., a concentration in one curve sector), that uncertainty is distributed to other assets, driving up vol. ratios. We’ve used some variation of the following charts on innumerable occasions of late and here they are again:
In case it’s not clear enough from the above, Kocic doesn’t think it’s particularly likely that rates vol. is likely to pick up sustainably from here. Uncertainty, he says, is “likely to take permanent residence” in other markets, “particularly in FX and equities where the next wave of repricing could become more substantial.”
That underscores a caveat we included in the first post linked above. In their piece on cross-asset vol. spike sequencing, SocGen mused that “if we are indeed moving towards a recession in the US, we could soon start to see a pick-up in FX and eventually in rates.” Our response was as follows:
Maybe, but remember, monetary policymakers have been extraordinarily successful at anchoring rates volatility. Indeed, there’s a strong argument to be made that a spike in rates vol. is simply a non-starter.