The Big Idea

Positioning for lower volatility

| July 21, 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.

With the Fed one or possibly two hikes away from keeping policy on hold for the rest of the year and likely well into next, interest rate volatility looks set to drop. That should make life a little easier for risk managers, but it should also be good for returns in risk assets—MBS and credit. Risk spreads clearly respond to changes in volatility, but not all spreads respond the same way. MBS near par along with consumer cyclicals and capital goods stand the best chance of outperforming if vol drops.

Falling volatility through the balance of the year might coincide with the Fed on hold, but it more fundamentally reflects growing consensus about the path for inflation. The Philadelphia Fed’s Survey of Professional Forecasters shows growing consensus on that. The Philly Fed publishes a measure of dispersion in forecasts for a wide set of measures, including inflation. And dispersion in inflation forecasts has fallen significantly since a peak late last year (Exhibit 1). Barring an uptick, more readings on inflation should strengthen consensus and interest rate volatility should drift lower.

Exhibit 1: A narrowing consensus on the path of inflation

Note: data shows the difference between the 75th and 25th percentile of forecasts for core CPI in the current quarter and for 1, 2, 3 and 4 quarters ahead. Source: Philadelphia Fed Survey of Professional Forecasters, Santander US Capital Markets.

As for risk assets, all are short or have sold some form of options on rates, credit or a combination. Agency MBS investors have sold prepayment options to homeowners. Investment grade and high yield investors have sold put or default options to borrowers, although the value of credit options should be correlated to rates through the common influence of expectations for the economy and the Fed. Non-agency MBS and callable corporate bonds have shorted a combination of both rate and credit options. It is the short position in options that creates spread to the Treasury curve. In markets with high expected volatility in rates or credit, options are expensive and spreads are wide. As volatility falls, option values drop and spreads tighten.

Expected volatility has moved around significantly this year, falling through January but then hitting historical highs after Silicon Valley Bank collapsed (Exhibit 2). With resolution of the debt ceiling crisis in early June and the Fed’s pause that month, vol has started to decline. It should continue to drop.

Exhibit 2: Expected rate volatility has varied significantly this year

Source: Bloomberg, Santander US Capital Markets

The big swings in expected rate vol have provided a natural test of its relationship to spreads in risk assets. It is straightforward to run a correlation between daily changes in in expected rate volatility, measured by the MOVE Index, and daily changes in asset excess returns. A move higher in vol usually comes with a move lower in excess returns, reflecting wider spreads. And a move lower in vol usually comes with a move higher in excess returns, reflecting tighter spreads. The correlation should be negative, and that is exactly what the data show so far this year for every major asset class, although the strength of the relationship varies. Squaring the correlation, which measures that amount of excess return “explained” by changes in vol, shows investment grade and corporate credit with the most sensitivity this year to vol followed by agency MBS (Exhibit 3).

Exhibit 3: Excess return across assets “explained” YTD by shifts in vol

Note: Squared correlation of daily changes in excess return and daily changes in the MOVE Index. Excess return for each asset class based on the corresponding Bloomberg index, except for leveraged loans, which is based on return from the Morningstar/LSTA index net of returns on the ICE BoA 3-Month Treasury Bill Index 12//31/22-7/17/23. Source: Bloomberg, Santander US Capital Markets.

The results at the level of the asset class can hide important details. Take MBS, for example. Most MBS this year has traded at a deep discount to par, meaning the prepayment option for most borrowers has been well out-of-the-money, reducing sensitivity to rate volatility. Looking at the level of individual 30-year coupons shows that the 30-year 5.0% and 5.5% coupon—the coupons trading closest to par for most of the first half of the year—show the most sensitivity to vol (Exhibit 4). Sensitivity to vol falls in lower coupons trading at the deepest discounts.

Exhibit 4: Excess return across 30Y MBS coupon “explained” YTD by shifts in vol

Note: Squared correlation of daily changes in excess return and daily changes in the MOVE Index 12//31/22-7/17/23. Excess return for each asset class based on the corresponding Bloomberg index. Source: Bloomberg, Santander US Capital Markets.

Aggregate results for investment grade credit also mask some important details. Here, the amount of excess return “explained” by shifting vol is roughly flat at around a third across different sectors. But consumer cyclicals, technology and capital goods lead by a small margin, while financials lag the rest of the group by a wide margin (Exhibit 5). Consumer cyclicals and capital goods arguably are the most sensitive to shifts in expected growth.

Exhibit 5: Excess return across IG “explained” YTD by shifts in vol

Note: Squared correlation of daily changes in excess return and daily changes in the MOVE Index 12//31/22-7/17/23. Excess return for each asset class based on the corresponding Bloomberg index. Source: Bloomberg, Santander US Capital Markets.

Similarly, in high yield, consumer cyclicals and capital goods show the most sensitivity to changes in expected volatility (Exhibit 6).

Exhibit 6: Excess return across HY “explained” YTD by shifts in vol

Note: Squared correlation of daily changes in excess return and daily changes in the MOVE Index 12//31/22-7/17/23. Excess return for each asset class based on the corresponding Bloomberg index. Source: Bloomberg, Santander US Capital Markets.

All else equal, exposure to near-par coupons in MBS and to consumer cyclicals and capital good in both investment grade and high yield corporate debt should get the biggest lift from a likely drop in volatility through the balance of the year.

* * *

The view in rates

OIS forward rates again this week put fed funds above 5.40% from September through December. The same forwards again anticipate 140 bp of cuts in 2024. The stickiness of core inflation suggests cuts in 2024 look premature, especially cuts of 140 bp. The Fed looks more likely to hold fed funds at a terminal rate well into 2024, something that would actually tighten financial conditions if nominal rates stayed constant and core inflation dropped. Under those circumstances, real rates would rise. That is likely the Fed plan.

Other key rate levels:

  • Fed RRP balances closed Friday at $1.77 trillion, a surprising rise of $30 billion in the last week. Treasury bill yields had been drawing cash away from the RRP facility since the June resolution of the debt ceiling crisis. But with bill yields now roughly where the RRP rate should end up if the Fed hikes on July 26, the RRP apparently is clawing some of the cash back.
  • LIBOR officially went away on June 30, so goodbye, old friend. Setting on 3-month term SOFR traded Friday at 535 bp, up 5 bp over the last week.
  • Further out the curve, the 2-year note closed Friday at 4.84%, up 9 bp in the last week. With the Fed likely to hike again and hold fed funds closer to 5.50% into next year, fair value on the 2-year note is above 5.00%. The 10-year note closed at 3.83%, up 2 bp in the last week. With inflation likely to drift down and growth likely to slow, fair value on the 10-year note is closer to 3.50%.
  • The Treasury yield curve closed Friday afternoon with 2s10s at -100, flatter by 5 bp over the last week. Expect 2s10s to flatten beyond -100 bp as the Fed keeps short rates high and concerns about growth and recession grip long rates. The 5s30s closed Friday at -19 bp, flatter by 7 bp over the last week.
  • Breakeven 10-year inflation traded Friday at 235 bp, up by 10 bp over the last. The 10-year real rate finished the week at 149 bp, down by 8 bp in the last week.

The view in spreads

The Bloomberg investment grade cash corporate bond index OAS closed Friday at 146 bp, tighter by 2 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 164 bp, wider by 4 bp in the last week. Par 30-year MBS TOAS closed Thursday at 53 bp, also wider by 4 bp in the last week. Both nominal and option-adjusted spreads on MBS have been particularly volatile in the last month.

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. But other parts of the market funded with floating debt look vulnerable. Leveraged and middle market balance sheets are vulnerable, especially with the tightening of bank credit in the wake of SVB. Commercial office real estate looks weak along with its mortgage debt. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans in September should add to consumer credit pressure.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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