Taming the Hurricane

TUE 31 MAY 2022

It is an obvious point, but volatility is a derivative of price itself. From our perch, there has been a notable moderation in bond and swaption volatility over the past few weeks (chart 1). That has also coincided with a correction in long end yields (recovery in bond prices) and a stabilization in terminal (neutral) rate expectations (with the 16th Eurodollar contract trading around 3%).

While the move in nominal yields has been large and the drawdown in fixed income returns has been material this year, valuation or inflation risk compensation in long end yields is still not attractive in outright or relative terms. Put another way, although we are sympathetic to a cyclical or tactical recovery in bond prices (fall in yields) the current episode is probably not an opportunity to load-up on fixed income.

Sometimes it is important to go back to first principles. The fair value of a 10 year Treasury is the future expected policy rate plus a premium for inflation expectations and a term risk premium. Of course, these variables are not independent. An increase in the future expected policy rate ought to moderate inflation expectations and reduce the inflation risk premium if the Fed remains credible. That is probably a key reason why the 10 year yield has tended to anchor (in an empirical and behavioral sense) around the 10 year moving average of the Fed funds rate (chart 2).

To be fair, a key factor that could lead to a rally in bond prices (fall in yields) is a material slowdown in growth momentum as that would probably lead to a moderation in actual inflation and inflation expectations.

While growth tends to remain resilient until policy rates move above neutral (roughly 3%) there has been a meaningful deterioration in key leading indicators such as the ISM, consumer sentiment and small business confidence. To be fair, underlying household income and consumption remains above trend and is the major contribution to final demand. Put differently, the current growth scare might be an emotional overreaction.

On inflation, the good news for fixed income is that goods price inflation and some sectors impacted by supply constraints has probably peaked. On the negative side some of the supply side constraints clearly remain persistent especially in the energy markets. It is also the case that the Fed has already tolerated a material acceleration in total employment costs relative to prior cycles or the typical reaction function (chart 3).

In conclusion, there has been a moderation in bond volatility over the past few weeks. That has coincided with a moderation in long end yields and a stabilization in terminal rate expectations. There has also been a moderation in 5 year 5 year forward breakeven inflation and a deterioration in leading indicators of growth that tend to lead the macro cycle and fixed income yields. However, two factors continue to leave us cautious on fixed income. First, the growth scare could be an emotional overaction given the underlying strength in household income. Second, real yields remain barely positive and offer very little inflation risk compensation. The related point is that the latter constrains the capacity of fixed income to provide diversification for equities.