If markets are returning to ‘fair value’ then how did we get this far from fair value in the first place? One answer lies with the catalysts that drove bond yields lower, which were highly synergistic: lower commodity prices meant lower inflation which necessitated additional monetary easing. More recently, with energy prices staging a nascent rebound, investors have begun to positively reassess the inflation outlook which had previously pinned down rates, particularly at the long end of the curve.
However just as the move lower was self-reinforcing, so too has the move higher. As higher inflation expectations pushed long-term rates higher, the reassessment snowballed into a sharp reappraisal of duration risk and led to a spike in volatility. With rate volatility resurfacing, investors were reminded that duration is a two way street and began to demand a higher term premium amid rising inflation expectations. From a technical standpoint, the sell-off gathered momentum as the rise in volatility caused managers targeting a stable value-at-risk (VaR) to shed positions in order to maintain the same VaR profile.
The unwind in rates has been particularly acute for bunds, which saw term premia compress even further than U.S treasuries. Europe obviously faced greater risk of deflation than the U.S., however, an arguably more powerful force behind the compression in term premia was the structure of the European Central Bank’s (ECB) quantitative easing (QE) program, which only purchases securities in the secondary market with yields above the -0.20% deposit rate. As short term yields fell below the ECB’s -0.20% QE purchase eligibility, speculation rose that the ECB would need to purchase a larger share of longer maturity securities to satisfy its QE program. As the rate sell-off began, however, and yields on shorter maturities rose back into eligible territory, the catalyst behind purchasing longer maturity securities began to fade for many investors. The result was a sharp repricing of long-term rates and a bear steepener in European and U.S. rates.
Despite similar yield curve moves and heightened volatility in both markets, there is an important difference in the sell-off that warrants close scrutiny. The market has not adjusted the expected timing of the first Fed hike, but in just three weeks, the market has nearly halved the time it expected the ECB to stay on hold, pulling forward expectations for the first ECB rate hike by over two years.
Number of Months to First Rate Hike
There are a few ways to view the relative stability of the market’s Fed rate expectations. Either the market has converged upon December as the initial lift-off date with a high degree of confidence and is not easily deterred, or the market has been under pressure from competing but equal influences, with weak 1Q15 data pushing out rate hike expectations and the recent price action pulling forward market expectations, as seen in the Eurozone. The relative stability in rate expectations should support lower volatility in U.S. markets relative to Euro markets as the market continues to reprice the outlook for ECB policy.
Regardless of when the first rate hike ultimately takes place, the recent volatility and market indecision should be welcomed by active managers. The recent price action has already led the 5s/30s treasury curve to steepen to its highest level in six months, presenting an attractive entry point for curve flattener trades going into the upcoming Fed hiking cycle. As U.S. growth rebounds from the 1Q15 weakness, short-term rates should continue to rise while the long-end finds a consistent bid due to a number of structural factors, leading the U.S. yield curve to resume its flattening trend as we approach the next rate cycle.