Rates Volatility and Risk Positioning – Taper Tantrum Reprisal or Renormalization?

In recent weeks, we have seen a significant rise in volatility in global interest rates led by a rise in US rates. While not surprising in the context of an improving macroeconomic outlook, the key question for investors is whether the selloff in rates is overdone in the context of dovish monetary policy, or whether it represents the beginning of a sustained rise in global rates with concomitant effects. Our view is that:

• The recent backup in rates is a rational response to improved growth as well as concerns about higher inflation.
• Given the nature of the recovery and the Fed’s ongoing commitment to easy monetary policy, we believe a sustained rise in rates beyond current levels is likely to present meaningful opportunities to extend duration and potentially benefit portfolios as we get through a period of higher headline inflation numbers.
  
• We see opportunities in emerging market debt (EMD) as it is more sensitive to a rise in US rates. In particular, we believe that local currency debt (rather than hard dollar debt) is relatively more attractive and likely to benefit more from sustained economic recovery.
  

The MOVE Index, which measures the normalized volatility of 1-month Treasury options, moved up nearly 20% during the last week of February. On February 25 the yield on US 10-year Treasuries moved nearly 24 bps from 1.37% to 1.61% intraday, a 4 standard deviation move. In fact, the rise in rates on February 25 paralleled the moves during other historic market events such as the Fed’s tightening in 1987 and the election of Donald Trump in 2016. The backup in rates over the last few weeks is not terribly surprising. COVID-19 cases have been receding globally, with 7-day average new cases decreasing from a peak of 768,000 on January 21 to 363,789 on February 20. Vaccine approvals and vaccinations have been picking up, and GDP growth estimates are being revised higher. The IMF revised its global economy growth forecast for 2021 to 5.5%, which is up 0.3 points from its previous forecast.

With accommodative monetary policy and new rounds of fiscal stimuli easing financial conditions, growth expectations are getting higher as global activity resumes. These dynamics are underpinning market expectations for a rise in inflation, as can be seen in the higher breakeven rates displayed in Exhibit 1.

Markets seem to be not only pricing in improved economic activity, but also pricing in expectations that the Fed will start to gradually unwind its accommodative monetary policy stance. Notably, a sharp spike in rates in the last two weeks was driven by a change in real yields rather than just by higher inflation expectations. As reflected in the forward curve, expectations of the timing of the next hike in rates shortened by nearly 12 months.¹ However, policymakers continue to reassure the market on their dovish stance. Jerome Powell, in his address to the House Financial Services Committee on February 24, stated: “Our policy is accommodative because unemployment is high and the labor market is far from maximum employment.”

The sharp spike in rates in recent days is a part of the normalization between rates and fundamentals. As noted earlier, fundamentals have been improving sharply with COVID case declines; however, rates remained under 1% until January 5. This disconnect was simply not sustainable in an economy that is projected to rebound sharply as the pandemic recedes. The question is whether rates have risen too much too soon, providing potential opportunities to add duration in portfolios.

To answer this question, we evaluate whether, in an absolute sense, the recent sell-off in US rates is driven by the market’s overreaction to future expected changes in monetary policy. As noted earlier, the Fed fund futures markets have tightened the timing of the next hike rather sharply. This is in contrast with the monetary policy stance highlighted earlier wherein Fed officials have repeatedly assured a dovish stance. While rates haven’t risen enough to create a clear disconnect with monetary policy, which would represent an opportunity to add duration, we feel that further increases will present meaningful opportunities.

On a relative basis, we monitor spreads of US Treasuries relative to other G6 sovereigns. A large spread typically creates a bid for US Treasuries. As can be seen in Exhibit 2, the gap between US Treasuries and other sovereigns around the world like bunds and gilts remains wide relative to past 1-year average spreads. For example, yields on 10-year Italian BTPs is typically 23 basis points higher than 10-year US Treasuries. Currently the spread is actually negative. As rates rise further, the gaps widen and present a meaningful spread opportunity to global investors to add US duration. This can provide stronger technical support to duration, particularly if USD can remain strong.  

Does it make sense to increase exposures to other, higher-yielding assets like high yield (HY) or EMD at this point? We find that when there is a rate sell-off, EMD has a higher beta to this sell-off than HY. Over the last 10 years, we find that a 10% rate sell-off has resulted in a sell-off in HY spreads about 15% of the time, whereas EMD spreads have widened 60% of the time. As rates sell off further, this co-movement of Treasuries and EMD can provide valuable opportunities to add to EMD broadly or to specific EM currencies that have sold off in sympathy with a sell-off in USD. We remain constructive on both hard currency and local EM debt, but we see greater opportunities in adding local debt exposure, particularly in countries with higher rates, manageable external debt risks, and exposure to a positive commodity outlook (e.g., Russia and Colombia).

While the recent rise in the US yields is part of the normal course of global recovery and reflation, it is far from a taper tantrum-type scenario (i.e., based on an expectation of a liquidity withdrawal), and the move so far appears reasonable relative to improving global growth expectations. At current levels (US 10-year Treasuries around 1.6%) we see somewhat limited opportunity for tactical long-duration positions. But the threshold to add duration is not far off, and it would take only a modest further sell-off in US rates to make duration attractive. Indeed, the carry and roll components of Treasuries are beginning to turn attractive in many countries, like the US and Australia. It is our view that the credible, dovish global monetary policy stance should anchor the curve, and further increases in yields may provide attractive opportunities to add duration in US Treasuries. If further increases in yields prove more destabilizing to global risk sentiment, the resultant widening of HY and hard currency EMD spreads may also provide investors with an opportunity to add value on a tactical basis. At present, we see some opportunity in local EMD, but given the generally higher levels of debt and lagging vaccination programs it is important to be cautious. We continue to monitor these opportunities globally to support our clients’ investment goals.