Economist's Insights

Uncertainty Leads to a Renaissance for Volatility

Jan 31, 2018

Global Sovereign Sell-Off Has Yields at the Highest Levels in Years, Market Nerves on Edge: The murmurings from market watchers have become increasingly audible as global yields have risen in recent months to their highest levels in several years. A rapid ascent in yields beginning in early September has pushed the U.S. yield curve outside of the top-end of its most recent trading range.  Not only has the degree to which yields have risen raised eyebrows, so too has the speed.  The 2-year Treasury yield closed yesterday at 2.12%, its highest level of the cycle and up 86 bps since September 8 (annualized change of over 200 bps).  The 5-year Treasury yield finished at 2.51%, its highest yield since April 2010 and up 87 bps over the same time.  The 10-year Treasury yield closed Tuesday at 2.72%, its highest yield since April 2014 and up 67 bps since September 8.  As has been the case for many years, global yields have moved directionally coupled with U.S. yields.  The German curve is similarly stretched with the 2-year bund yield hovering at its highest level since June 2016, the 5-year yield near its highest level since November 2015, and the 10-year bund yielding the most since September 2015. In Japan, the Japanese 10-year yield is at 0.09%, the furthest it’s been from the Bank of Japan’s 0.00% peg since July 2017.


Better Growth, Firming Inflation Driving Fears of Less Support from Central Banks: Balance sheet expansion from the world’s most influential central banks and the adoption of negative rates by some have been major forces holding down longer yields.  However, stabilizing global inflation measures and signs of a pick-up in growth have resulted in speculation that the days of abundant accommodation from global central bankers may be numbered.  A significant tax cut for corporations and individuals in the U.S. has further raised global growth projections, making the concern more acute.  With every release of positive economic news, investors are growing increasingly fearful of the market reaction to less-supportive central banks.  As it relates to balance sheet holdings, the U.S. Fed is now letting its balance sheet shrink, the ECB has slowed its asset purchase program, and the Bank of Japan has slowed its balance sheet growth as a result of its yield peg.  Simply, there are fewer bonds being purchased by central banks today and investors fear there will be even fewer by the end of 2018.  As for the ECB and BoJ’s negative target rates, those do not appear to be going anywhere anytime soon.  However, markets focus on future actions and the improving backdrop has made the prospects of an end to negative rates, at the very least, plausible.


Implications of Higher Rates – Uncertainty and Volatility: The changes in global yields have raised several important questions, one of which is what higher rates will mean for other markets. A seemingly indestructible equity bull market has shown a rare sign of angst this week after global yields broke above key technical levels. After rallying nearly 17% since September 8, the S&P has dropped 1.8% over the last two days of trading, the biggest two-day decline since May 2017. Investors are being faced with questions they haven’t been forced to answer in years. How will higher interest rates affect the relative value of equities? How will higher interest rates affect the borrowing costs and bottom lines of corporations? Another important question is to the sustainability of the run higher in rates. Will the momentum that has lifted global yield curves persist? Or will rates level off into new ranges?  These questions have finally yielded a healthy increase in volatility – one that is unlikely to go away so long as the global-central-bank put is less certain.


Going Forward – Follow Inflation:  Global growth is indeed stronger and more broad-based, and inflation pressures have perked up in the major economies. But will it be enough to drive more central banks, specifically the ECB and BoJ, away from years of accommodation? And if it is, at what pace will they back away? Both of these central banks face a single-mandate of stable inflation.  While both have recognized a slightly firmer trend, core inflation in both regions remains well below their respective targets. Going forward, it will be important to watch the trends in incoming global inflation data and assumed leading indicators such as unemployment levels and the rate of wage gains. It will also be key to follow developments in the communications from the leaders of these central banks to gauge how confident they are in their economies and their ability to successfully remove the policy punchbowl without creating a harmful disruption for the markets and global economy.