The Big Idea

The low liquidity, high volatility, term premium regime

Steven Abrahams | November 10, 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. This material does not constitute research.

As the Fed gets closer to at least a temporary pause, some of the more subtle effects of tighter policy have become clearer. Money market mutual funds and other proxies for high policy rates continue to pull cash away from other parts of the system, and QT continues to pull cash out of the system. Lower liquidity has become a regular feature of the landscape along with persistent volatility and the slow return of term premium to the Treasury yield curve. We have moved into a new market regime likely to affect asset valuations for as long as policy remains tight.

Even though the Fed first hiked on March 16, 2022, it only deployed all of its tools for tightening once QT began on June 1, 2022. From that point, at least three measurable market fundamentals started to change in concert:

Indicators of market liquidity such as Treasury note bid-ask, order book depth, the price impact of large flows and the intraday dispersion of Treasury yields started to signal lower liquidity
The volatility implied by short options on interest rates began to rise, and
The term premiums in the Treasury yield curve estimated by a number of models rose above multi-year averages, although measures of those premiums had started to rise earlier in the year as the Fed signaled imminent tightening

The New York Fed has noted some of these relationships, although its analysis has focused on the bank failures of March 2023 rather than linking them to the onset and progress of Fed tightening.

It is tempting to link these results to monetary tightening and argue that lower liquidity limits investors’ ability to police markets and makes them more volatile, and that volatile markets lead investors to demand more term premium as compensation for bearing interest rate risk. The data broadly support the argument although falling short of proving cause-and-effect.

First, liquidity and volatility are clearly correlated and show a shift from high-liquidity-and-low-volatility before June 1, 2022, to lower-liquidity-and-higher-volatility after. One way to see this is to look at the intraday dispersion of Treasury yields as a measure of liquidity—low dispersion implying lots of liquidity for policing mispriced assets and high dispersion implying less liquidity—and compare that to implied rate volatility using the MOVE index, a blend of volatilities implied by 3-month options on 2-, 5-, 10- and 30-year rates (Exhibit 1). As yield dispersion rises, the MOVE index tends to rise. And while dispersion was relatively low before June 1, 2022, it has run substantially higher since.

Exhibit 1: As markets become less liquid, options imply higher expected volatility

Note: Data from 11/6/18 to 11/6/23.
Source: Bloomberg, Santander US Capital Markets

As every beginner statistician knows, correlation is not causality. But we can test for Granger causality between liquidity and volatility by trying to explain current changes in volatility using past changes in liquidity. That analysis shows changing liquidity Granger causes changes in volatility with a statistical significance of less than 0.01%. A test of the reverse relationship by trying to explain changes in liquidity by using past changes in volatility shows no significant results.

The link between volatility and term premium is weaker, although recent work here on fundamental drivers of 10-year Treasury rates argues that interest rate volatility has a significant impact, presumably by changing term premium. Data from recent years shows that higher rate volatility coincides with higher—or less negative—term premium mainly as the measures shifted from before June 1, 2022, to after (Exhibit 2). Of course, other factors can affect term premiums, clouding the link to volatility. Nevertheless, higher vol and higher term premium go together over this window.

Exhibit 2: Higher vol after June 1, 2022, has come with higher term premiums

Note: Data from 11/6/18 to 11/6/23.
Source: Bloomberg, Santander US Capital Markets

The combination of lower liquidity, higher volatility and higher term premiums has potential to create plenty of market surprises:

Higher rates than the fundamentals of inflation and real rates might predict
Wider spreads between riskless and risky assets
Wider spreads between liquid and relatively illiquid assets
Wider spreads between assets that embed at-the-money rather than out-of-the-money options

This looks like the raw material that will make the markets while the Fed keeps policy tight through most of 2024.

* * *

The view in rates

Fed funds futures put the chance of a hike at the December or January FOMC at less than 15% and then begin pricing for cuts afterwards. The implied probability of a cut exceeds 50% by the July 31, 2024, meeting. And the market prices for almost three cumulative cuts by December of next year. The risk in the funds futures is that inflation proves more persistent and that the Fed holds rates high into September before any cuts. Fed Chair Powell after the November FOMC described risks as “more balanced,” presumably meaning no tightening or easing bias. The Fed path may pin 2-year rates around 5%, but the lack of a clear tightening bias should help longer rates slowly rally.

Other key market levels:

Fed RRP balances closed Friday at $1.03 trillion as the facility continues to decline, down $39 billion in the last week. Money market funds continue to move cash out of the RRP and into higher-yielding Treasury bills.
Setting on 3-month term SOFR traded Friday at 538 bp, unchanged in the last week
Further out the curve, the 2-year note closed Friday at 4.84%, up 22 bp in the last week. Given the likely Fed path, fair value on the 2-year note is above 5.00%. The 10-year note closed at 4.65%, up 8 bp in the last week. At that yield, the 10-year note looks attractive relative to many risk assets.
The Treasury yield curve closed Friday afternoon with 2s10s at -41, flatter by 14 bp in the last week. The 5s30s closed Friday at 8 bp, flatter by 18 bp in the last week.
Breakeven 10-year inflation traded Friday at 234 bp, down 6 bp in the last week. The 10-year real rate finished the week at 232 bp, up 14 bp in the last week.

The view in spreads

The lack of a clear tightening bias and a Fed shift to “more balanced” risks should reduce rate volatility and help spreads, but lower liquidity is likely to offset stability in policy and keep volatility elevated in spreads wide and volatile. The Bloomberg investment grade cash corporate bond index OAS closed Friday at 155 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 173 bp, wider by 6 bp in the last week. Par 30-year MBS TOAS closed Friday at 67 bp, tighter by 6 bp in the last week. Both nominal and option-adjusted spreads on MBS initially snapped tighter after the November FOMC, likely reflecting mutually funds suddenly less worried about redemptions and liquidity and more interested in relative value in MBS. But fair value in MBS is likely closer to 70 bp, so the subsequent widening toward 70 bp looks reasonable.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against higher interest rates, but a lot will depend on how long rates remain high. 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. Less than 7% of investment grade debt matures in the next year, so those balance sheets have some time. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.

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

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