Nearly two months ago we wrote an article suggesting that equity market valuations were well under-pinned by the unprecedented monetary easing. This article looks at the very different picture in bond markets, where we are braced for some bumps.
There is the same background of very easy money, of course. End September data from our friends at CrossBorder suggests that every major central bank, except for the People’s Bank of China, has their foot pressed to the floor. As importantly, private credit creation stands at 83.1 (range 0-100), meaning that the combined liquidity environment is close to being as loose as it ever has been.
Despite this, perhaps because of this, there are some stretched relationships in the bond markets. The MOVE index of US Treasuries’ implied volatility across the curve is at a 30-year low, whereas realised volatility has more than doubled over the past 12 months and is close to the upper end of its normal range. The standard explanation for this is that the Federal Reserve is controlling the yield curve as part of its ‘forward guidance’ policy. We are sceptical and would rather point the finger at bond traders depressing implied volatility by selling put and call options.
Whatever the cause, historically the relationship between implied and realised has reverted to the mean, and we suggest that this time will be no different. We expect implied volatility to jump upwards, quite possibly as a result of actual volatility rising, if that forces bond traders to close out their positions.
And a surge in actual volatility would, in our eyes, be a normal consequence of the vast monetary easing. As this money hits markets and the economy, investors’ risk appetite rises. They move assets away from safe assets such as long dated bonds, and invest in both the economy and riskier financial assets such as equities, causing bumps in the markets. One implication of our view is that we are more positive about the economy than many. Our central view is that the world’s economy will heave itself off the floor and rumble ahead.
We see plenty of candidates for how bond market volatility might rise. If past relationships hold we would expect the ‘fear gap’, as CrossBorder Capital call it, or the spread between current bond yields and where they should theoretically be, to revert to mean. That would lead to 10 year US Treasury yields rising around 130bps to 2% or so. That may seem impossible today but that’s where they were 15 months ago.
Another banker for increased volatility is a steepening in the yield curve. The correlation between CrossBorder’s liquidity data and the yield curve is one of their strongest, and the recent surge in the former strongly implies a much steeper slope.
There is a question as to whether it takes place as a ‘bear’ steepening, ie. higher yields at the long end, or a ‘bull’ one with short yields going lower still. Some will see plentiful money creation as a recipe for even lower money rates but our money is on higher long bond yields. This is not just because that is normal as economies exit a recession but also because, while central banks can influence short rates, at the long end old-fashioned buying and selling is a more powerful driver of yields. In this case, we know that foreign investors own around 40% of US Treasuries (NB. the number was 1% in 1945) and that the Chinese will be selling down some of their approximately US$1trillion of holdings. The big question further down the track is whether other assets will remain calm if bond markets become more turbulent. In our view it would be unusual if they did, but that’s probably round the next corner. If you’d like to find out more, please contact us.