In just two years, everything changed.
The pandemic, and then, a ground war in Europe, together shattered a three-decade period of relative macro stability, upending what too many market participants came to regard as unassailable “truths,” including the notion that inflation in developed economies was destined to remain moribund in perpetuity.
Relatedly, bedrock risk management principles, including the purportedly “foundational” negative correlation between equities and bonds, were exposed as ephemeral manifestations of an anomalous peace.
One poignant manifestation of markets turned upside down is the backwards sequencing of volatility propagation, something SocGen’s cross-asset team explored in a new note, dated September 14.
For four decades, cross-asset volatility has (generally) migrated from equities to commodities to FX to rates. “Rates volatility has been the last to surface because, in the absence of high inflation, the right-tail risk in rates is minimal, and with no right-tail risk in rates, volatility manifests itself only when there is risk of a sharp move lower in rates,” typically during periods of “weak growth, demand for safety in bonds, deflation risk and central banks cutting rates,” analysts including Kokou Agbo Bloua, Jitesh Kumar and Sandrine Ungari wrote.
This time, it’s different. “The sequence has been turned on its head,” as SocGen put it. Central banks’ increasingly panicked efforts to coax the inflation genie back in the bottle have resulted in violent selloffs in rates and associated volatility.
The dominance of rates vol is new. Or, at least it seems that way to many market participants, although I imagine some rates derivatives specialists would quibble with that notion. The figure on the left (below) shows cross-asset vol levels expressed in terms of their 10-year averages. Rates vol is the clear outlier. It’s a black swan.
The figure on the right (above) shows rates vol’s dominance.
Of course, some of this is by design. The Fed sought to enlist volatility — the “best policeman of risk assets” — in the inflation fight. But rates volatility is perilous. Especially considering the extent to which unbridled fiscal policy and unruly commodities could mean docile bonds, domesticated by decades of structural disinflation and a dozen years of forward guidance, become lawless, and difficult to tame.
If that turns out to be the case, the read-through for other assets is ambiguous, at best. “Volatility seen in many other asset classes this year has not been of the classic kind, but rather, a second order effect of rates volatility,” SocGen went on to say, noting that “a big chunk of total return drawdowns in credit are a result of higher sovereign rates [while] in equities, earnings have in fact held up quite well given investor pessimism overall, and most of the drawdowns are a result of valuation compression.”
Coming full circle, and returning to a topic that’s becoming more urgent by the week, it’s imperative we consider the possibility, as disconcerting as it most assuredly is, that in fact, nothing has changed. That “The Great Moderation” was no epoch. Perhaps the great macro peace was merely an interlude.
It’s possible — likely, even — that we forgot what normal actually is. Normal is volatility. Normal is rancor. Normal is war.
Read more: What If ‘Normal’ Isn’t What We Think It Is?