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The Upside of Bond Market Volatility

Stocks swung wildly in late January and early February, and while the bond market may have provided the spark, the embers were smoldering in the stock market for quite some time. It was the sudden unwinding of short volatility trades, which are leveraged bets that volatility will remain low, that set off the fireworks. When traders had to exit these trades, the door wasn’t wide enough for everyone to get out unsinged.

These “short-volatility” traders simply overstayed their welcome. The trades worked well during the quantitative easing (QE) era—when central banks around the world were buying government securities to increase the money supply and lower interest rates—because QE suppressed volatility along with bond yields. That provided a rare opportunity to get high returns in risk assets without the usual volatility. However, with central banks unwinding QE, it was inevitable that yields and volatility would rise. They apparently rose a lot faster than most of these traders expected.

It’s always easy to second-guess, but I wonder how they missed the signals. It’s not like the Federal Reserve has kept its plans a secret. The federal funds rate target has been raised five times since December 2015, and the balance sheet reduction plan has been clearly spelled out for years. The European Central Bank has also been straightforward about its intentions to pull back on QE. Moreover, global bond yields have been rising sharply since late last year, reflecting an improving growth outlook and ebbing deflation pressures. Lastly, inflation expectations have surged in recent months.

Inflation expectations have been rising and are above 2%.

The 5-year/5-year forward breakeven rate has risen this year, and was at 2.21% as of February 9, 2018.

Note: Based on the 5-Year/5-Year Forward Inflation Expectation Rate, a measure of the average expected inflation over the five-year period that begins five years from the date the data are reported. 
Source: Bloomberg, daily data as of 2/9/2018.


Perhaps the surprise is how little it took to light the volatility spark. The Fed has only begun to reduce its balance sheet. As of the end of January, it had only trimmed $20 billion from its $4.5 trillion total holdings. A key factor seems to be Congress, which recently passed tax cuts and spending increases at a time when the economy is nearing capacity constraints—a classic prescription for inflation. With the prospect of rising inflation and higher budget deficits, there is now anticipation that the Fed may tighten monetary policy more and at a faster pace than appeared likely just a few months ago.

The steepening yield curve reflects concerns about increased supply and rising inflation expectations.

The difference between the two-year Treasury yield and the 10-year Treasury yield has widened to 74.3 basis points as of February 9, 2018.

Note: The spread is a calculated yield spread that replicates selling the current two-year U.S. Treasury Note and buying the current 10 year U.S. Treasury Note, then factoring the differences by 100. Source: Bloomberg, daily data as of 02/09/18.

Another change in the market is the attitude of the Fed. Based on the futures market, the implied probability of three rate hikes this year actually declined last week due to the volatility in the markets. However, several Fed officials spoke over the past few days and none indicated that the selloff in the stock market was a concern. In fact, New York Fed Bank President William Dudley called it “small potatoes.” Unless the market decline causes a problem in the financial system or there is evidence it’s affecting the real economy, the Fed is likely to continue on its tightening path. That would mean three to four rate hikes this year and a terminal federal funds rate of 2.75%.

Repricing risk

Despite the drama, there is good news for the average investor in what has happened over the past few weeks. Markets are repricing risk to more realistic levels without the pain of an economic downturn. That’s good news.

Many times, repricing of risk is driven by a recession or fundamental imbalance in the global economy. That doesn’t seem to be the case this time around. Consequently, after the selloff runs its course, there should be more reward for risk-taking than there was just a few weeks ago. For bond buyers, it means there may be opportunities on the horizon to reinvest at higher yields without commensurately higher risk.

Investors could consider adding some duration to portfolios as yields move higher. However, in the near term, there may be more turmoil ahead. Yields and spreads don’t appear to be at levels that fully discount the changed outlook. Since Thanksgiving, two- and 10-year Treasury yields are up about 60 basis points each (a basis point is 1/100th of a percent, so 60 basis points equals 0.60%), but the absolute level of yields is still probably too low.

Moreover, the term premium—the extra yield you get for investing in longer-term bonds rather than holding short-term paper—is still negative by about 20 basis points. In theory, in a world where deflation is not a big threat, the 10-year term premium should be positive.

The term premium for 10-year Treasuries is still negative.

The term premium for 10-year Treasury bonds was negative 0.21% as of February 8, 2018.

Source: Federal Reserve Bank of New York, daily data as of 02/08/18.

What investors should know now

These types of episodes of heightened volatility are likely to become more common as the era of easy money ends. It will be worth watching just how interest-rate-sensitive the economy is longer term. Debt levels are high at the consumer, corporate and government levels, which could constrain growth and inflation down the road. It would not be surprising to see 10-year Treasury yields peak in the 3% to 3.25% region and then trend lower later in the year as the yield curve flattening trend resumes. But that’s probably a consideration for the second half of the year—not the first half.

Because we expect the economic outlook to remain sound, an increase in yield spreads in these markets could present an opportunity for investors. Often risk is repriced in markets during recessions or periods of global turmoil. This time around, the repricing is taking place against a backdrop of solid economic growth. Consequently, investors may have the chance to add income without necessarily adding significant credit risk.

What you can do next

  • Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.

  • Explore Schwab’s views on additional fixed income topics in Bond Insights.

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Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Investing involves risk including loss of principal.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.


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