Trending
Written by: JB Golden | Advisor Asset Management
The Zero Interest Rate Policy (ZIRP) era is generally viewed as the 10-12 years of coordinated central bank policy in the aftermath of the 2008 Great Financial Crisis. It included the lowest interest rates in modern history and had significant impacts on the global financial system; one impact was muted interest rate volatility. The ICE BofA MOVE Index measures U.S. Treasury market volatility, and while the measure can be quite volatile in the short run, considering it over longer time periods could be informative. From 1960 to 2008 the MOVE Index averaged 102.5. From 2009 to 2020 — generally considered to be the ZIRP era — the index averaged 76. There is a myriad of drivers behind interest rate volatility, but any framework for consideration likely includes the economy, inflation, central bank policy and geopolitical concerns. While there could be other catalysts for volatility there is likely a good chance that the higher the uncertainty in these four factors, the higher the probability for rate volatility.
Interest rate volatility spiked significantly ahead of the U.S. presidential election then fell back to near-term averages the day after Donald Trump was elected president. Off the cuff it might seem like the election was the reason for the volatility, but correlation is not necessarily causation, and it could be a mistake to infer that it was the election itself that was the driver or that the subsequent drop was a function of who was elected. The market seemed to view both candidates’ policies as inflationary and expansive, in regard to the deficit, albeit for different reasons. While a near-term catalyst, the election has passed the long-term drivers, concerns over the economy and inflation have not passed. In fact, consideration of the four factors mentioned previously would tend to indicate that as 2024 winds down, there might be more rate volatility in store. In addition, they should serve as a reminder that the Federal Reserve is not the only driver of interest rates. As interest rate markets normalize, post-ZIRP, interest rate volatility could remain well past the point the Fed’s job is done.
In just the last year, the 10-year U.S. Treasury has traded in a range of over 140bps (basis points). In late October 2023, the 10-year was sitting just shy of 5% before trading down to 3.60% by September 2024. In the last 60 days, markets have reversed course, and the 10-year is back up to just shy of 4.5%. The economy, concerns over inflation and changing expectations for Federal Reserve policy have all played a role. Surprisingly, with two regional conflicts and recent escalations in the Ukraine-Russian war, geopolitics have not played as large a role as one would expect. Since the first Fed rate cut in September, the economic picture has only gotten murkier, and it is hard to envision a scenario in which markets do not continue to grapple with rate volatility.
After the first 50bps rate cut of the current easing cycle, on September 18, 2024, the U.S. Treasury market was pricing almost eight additional rate cuts by the end of 2025 with a projected Fed Funds rate of 2.879%. By the end of last week, markets were pricing in fewer than three rate cuts and a year-end 2025 Fed Funds rate of almost 4%. Treasury Inflation Protected Securities (TIPS) breakevens — an implied measure of the bond market’s inflation expectations — have moved up sharply in the last couple of months as markets digest the notion that the Fed may have underestimated the stickiness of inflation. Since the beginning of September, the 2-year TIPS breakeven is up almost 120bps while the 5-year TIPS breakeven is up approximately 60bps. On the economic front the strength the U.S. economy has exhibited this year has been surprising for many. The recent resteepening of the yield curve would tend to indicate a market pricing in higher long-term growth expectations, but more recent data on the labor market would tend to indicate a bit of weakness is beginning to creep into the data. While initial jobless claims last week dropped to their lowest level since April, continuing claims jumped to a three-year high and would tend to indicate it is taking workers longer to find employment. Seasonal demand could keep initial claims low through the balance of the year, but the labor market has a host of layoff announcements from companies such as Boeing to grapple with to start the new year. On the geopolitical front, as the Ukraine-Russian war drags on past 1,000 days, it very much appears we are in the midst of an escalation of the conflict. In the last 90 days we have seen an increase in uncertainty surrounding the U.S. economy, inflation, geopolitical concerns and the Fed’s path forward on monetary policy. Taken in totality, it seems like it could be a recipe for a continuation of volatility in U.S. rate markets.
Uncertainty may abound, but the good news for most fixed income investors is that they might be able to avoid much of the potential rate volatility by sticking to one rule of thumb, in our opinion. We believe investors should consider avoiding the most interest rate-sensitive areas of the market without more information. Geopolitics might create volatility to the downside, but the balance of factors would tend to indicate volatility is here to stay and long-term rates could be biased to the upside, further supported by a rising U.S. fiscal deficit. Recently, long-term rates have been moving higher which has led to a resteepening of the yield curve. Term premiums are returning to the market, which could reflect a return to a more normalized environment. However, there is a meaningful difference in rate sensitivity between the intermediate and long end of the yield curve. The 10-year U.S. Treasury has an effective duration of approximately eight years while the 30-year Treasury has an effective duration of over 16 years. While the curve is steepening, the spread between the 10-year Treasury and the 30-year Treasury remains a paltry 18-20bps. This does not seem to be adequate compensation for accepting twice the interest rate risk. An intermediate or market neutral duration seems more appropriate given the backdrop. Yields in the intermediate space offer slightly lower yields for less risk while maintaining the dry powder needed to use the volatility to your advantage. We consider volatility as an opportunity but consider exercising caution on longer duration assets.
Related: Are U.S. Tariffs a Threat to Canada’s Stock Market?