The Big Idea

Volatility withstands a February rise in rates

| February 24, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Even though US rates have bounced higher lately, implied rate volatility has not followed in sympathy. Implied vol has moved up but not nearly as much as the rate curve. That benign response suggests a market increasingly comfortable with a narrowing range of rate outcomes compared to the possibilities it saw at peak rates in the fall. And surveys of economists back up that intuition. Rate vol looks more likely to diminish than, not in the months ahead. And that should help nominal spreads in risk assets.

US Treasury yields declined from October into February before starting to retrace. Yields on the 2-year note, for instance, dropped from 4.50% in October to 4.09% at the start of February and have now erased the drop and set a new high (Exhibit 1). The 5-year note dropped into February and has retraced 83% of its move. And the 10-year note also dropped and has retraced 65% of its move.

Exhibit 1: US rates lately have retraced much of the drop from last fall

Note: All rates shown as percentage.
Source: US Treasury, Santander US Capital Markets

Implied rate vol has not followed. It declined from October into February but has retraced much less since. Implied annual volatility from 1-month options on 2-year notes, for example, dropped from more than 162 bp in October to just above 103 bp in February but have only retraced 64% of the move (Exhibit 2). Implied annual vol from 1-month options on 5-year notes lately has retraced 57% of its October-to-February move. And implied vol from similar options on 10-year notes has retraced only 36% of its move.

Exhibit 2: Implied US rate volatility has retraced less of its drop

Note: All implied volatilities shown in basis points annually.
Source: Bloomberg, Santander US Capital Markets

A range of studies have found that implied volatility from short options historically does a reasonable job of predicting realized volatility over short horizons. If history holds, then realized rate volatility over the next month at least should stay well below the levels of last fall.

Going beyond the options markets, the latest Survey of Professional Forecasters from the Philadelphia Fed also gives reason to expect rate volatility to run below last year’s levels. The Philly Fed asks survey participants to forecast a range of economic variables and then reports, among other things, the dispersion across forecasts—the difference between the 75th percentile and the 25th percentile forecast on each variable. With a continuing Covid rebound, the Russia-Ukraine war, supply chain disruptions, lockdowns in China and aggressive Fed policy, predicting most variables in 2022 turned out to be extraordinarily difficult and dispersion rose to historic levels. Forecasters surveyed in mid-2022 for a view on annualized CPI in the last quarter of that year, for example, showed dispersion of 268 bp—well above the historical dispersion in that series of only 86 bp (Exhibit 3). Dispersion began to decline in the fourth quarter of 2022 has declined again with the survey released February 10.

Exhibit 3: Forecasters’ expectations narrow for CPI, other economic variables

Source: Philadelphia Fed, Santander US Capital Markets

In all likelihood, expectations around inflation, employment and growth and Fed policy will continue to stabilize in the months ahead despite healthy debate about the nuances and interactions between each force in play. There are some wildcards—the US debt ceiling showdown due this summer and any shift in Japan’s yield curve control could add new uncertainty and lift volatility—but absent those, fundamental uncertainty and volatility should continue declining.

For risk assets, a decline in volatility usually comes with tighter spreads, which get reflected in improving excess return. Holders of agency MBS, for example, have sold a prepayment option to borrowers and collect the option premium through additional nominal spread. When expected rate volatility falls, the value of the prepayment options falls, too, and the fair nominal spread on MBS tightens. Holders of credit have sold a put option to equity shareholders, as Robert Merton famously argued, and declining macro volatility makes that put option less valuable. Since the start of 2022, as just a recent example, changes in rate volatility have correlated negatively with most MBS and credit spreads—rising vol leading to wider spreads and lower excess return and falling vol leading to tighter spreads and higher excess return (Exhibit 4).

Exhibit 4: Correlations between volatility and asset excess returns

Note: Data shows correlation from 1/1/2022 to 2/22/2023 between daily change in asset excess returns and daily change in the MOVE index. Asset excess returns based on the corresponding Bloomberg index, except leveraged loans based on the Morningstar/LSTA index.
Source: Bloomberg, Santander US Capital Markets.

Declining volatility along may not offset shifts in supply and demand or changes in changes in other asset fundaments. But expectations for lower volatility than last year have held despite the recent rise in rates. And there’s good reason to expect volatility to continue declining and helping risk asset performance.

* * *

The view in rates

OIS forward rates have become more hawkish than the Fed’s December 2022 dots, approaching 5.50% now by August this year and closing December 2023 at 5.35%. Persistent inflation, including the January month-over-month PCE core deflator—the Fed’s favorite measure—have persuaded the market that the Fed will keep raising rates. Just as the Fed has been predicting for months.

Fed RRP balances closed Friday at $2.14 trillion, up $83 billion from last week. Despite apparent Fed expectations that attractive rates in money markets will draw funds away from the RRP, it clearly is not happening yet.

Settings on 3-month LIBOR have closed Friday at 495 bp, up 8 bp on the week. Setting on 3-month term SOFR closed Friday at 489 bp, up 13 bp on the week.

Further out the curve, the 2-year note closed Friday at 4.81%, in the neighborhood of fair if fed funds climb just above 5.0% and remain there into mid-2024. The 10-year note closed well above fundamental fair value at 3.84%, up 21 bp on the week.

The Treasury yield curve has finished its most recent session with 2s10s at -87 bp flatter by 9 bp over the last week. The 5s30s finished the most recent session at -28 bp, flatter by 18 bp over the last week. The 2s10s curve looks likely to invert by around 100 bp shortly before Fed tightening comes to an end. That should come by mid-year.

Breakeven 10-year inflation finished the week at 237 bp, up 3 bp in the last week. The 10-year real rate finished the week at 157 bp, up 17 bp in the last week.

The view in spreads

Volatility has move up modestly in February but should trend down with each reading on inflation and employment and each Fed meeting. Each number and meeting should give more clarity to inflation, growth and Fed policy. Both nominal MBS and credit spreads should tighten as volatility drops. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields closed Friday at 149 bp, up 1 bp on the week. Par 30-year MBS TOAS has closed Friday at 50 bp, tighter by 5 bp on the week.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. Leveraged and middle market balance sheets are vulnerable, especially with the sharp tightening of bank credit. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. In leveraged loans, a higher real cost of funds has already started to eat away at highly leveraged balance sheets with weak or volatile revenues.

Steven Abrahams
1 (646) 776-7864

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