TUE 22 MAR 2022
In automotive terms, if the delta of an option is its speed, then gamma is the acceleration. This analogy can also be extended to the relationship between duration and convexity in fixed income or the non-linear relationship between the change in interest rates and bond prices. Earlier this year we argued that a key reason why there is always such a strong resistance to consider extreme outcomes like monetary policy reversals, inflation persistence or higher neutral rates is that most investors are naturally short convexity. Stated differently, the real world is not linear and systemic risk can increase at an accelerating rate as correlation moves towards one in a major episode.
From our perch, it is not surprising that recent price action in the bond market has become impulsive, rapid and emotional. In spite of the “Volcker-like” communication from Jay Powell, the Fed is so far behind the curve on policy normalisation it is (literally) not funny. While there has been an increased urgency in promises from the Fed, they have only delivered 25 basis points at the March FOMC with headline inflation at 7.9%. Put another way, the absence of assertive action from the Fed might be the reason why yields have started to move in an impulsive and non-linear way, leading to a rapid recalibration of consensus beliefs on short-term market interest rates.
For investors, the not-so-subtle point is that an increase on bond market volatility is kryptonite for assets that are naturally short convexity. Historically, phases where fixed income yields rise sharply and rapidly tend to lead to a rise in cross asset volatility, tightening in dollar liquidity and financial conditions (chart 1). As we often note, there is an intimate link between liquidity, volatility and leverage.
The other important question that market participants are quite rightly focussed on is; flattening of the yield curve. While this has become the focus of a “single story” or a widely observed development, severe flattening and inversion in the belly of the curve (3-7/10 year) has historically been a reliable indicator of a growth scare or recession. Of course, the lead time is up to 18 months. Nevertheless, it is a legitimate indicator of the risk to macro conditions as tightening takes effect and growth slows. It is also a plausible reason why equities sensitive to the cycle – US small companies – have underperformed large companies over the past year (chart 2).
Other leading indicators of the macro cycle such as consumer expectations and the ISM index have also moderated over the past few months (chart 3). The later is often correlated with the direction of 10 year yields and might suggest that the recent move in yields is well advanced. Of course, the overall level is still low in a historical context and compared to neutral or terminal policy rates. Recall that the “fair value” of the 10 year is; future expected short rates plus a premium for term, liquidity and inflation risk.
The positive interpretation on the current phase of volatility is that the growth scare implied by some leading indicators is an emotional overreaction. After all, the labour market remains firm in the United States and credit risk premiums are still modest relative to other historical episodes. It is possible that some of the weakness is also explained by the rotation from “buying stuff” (goods) to “doing stuff” (services). Time will tell. We are also sympathetic to the “hotter, shorter” cycle thesis in this episode. While rising interest rates are not necessarily negative for risk assets if associated with robust growth and profits, large impulsive moves in yields (in both directions) often coincide with an increase in cross asset volatility. We have zero exposure to fixed income and a decent allocation to cash for optionality.