Rising real interest rates haven’t yet made for a sustained pickup in Treasury volatility, leaving some investors to ask what it would take to spark some turbulence.
Danielle DiMartino Booth of Quill Intelligence said the European Central Bank, and not the Federal Reserve, holds the key as it looks to set a timetable for winding down its ultra-accommodative policies. With the Federal Reserve’s shrinking balance sheet unable to offset easy global financial conditions on its own, investors should closely watch the ECB at Thursday’s meeting where the central bank is expected to discuss the end of quantitative easing, though the actual wind-down almost certainly remains several months away at the earliest.
“The culmination of ECB QE will remove a bond-volatility governor,” said Booth, in a note published on Tuesday.
In the past, the 10-year inflation adjusted, or real, yield would closely track gauges of bond volatility as measured by the Bank of America Merrill Lynch MOVE index, the equivalent of the stock market’s VIX index VIX, -1.38% which measures implied volatility for the S&P 500 SPX, +0.08% Since 2008, the real yield for the U.S. benchmark bond and the MOVE index has showed a correlation of 0.76. Correlation is a measure of the degree to which two assets move in relation to each other. A perfect correlation of 1.0 means they move in lockstep, a reading of 0 means they move independently of each other, and a reading of minus 1.0 means they move in a perfectly inverse relationship.
The positive correlation has weakened the last few months. Even as the inflation-adjusted yield steadily rose to 0.83%, a more than 60 basis point climb since Sept. 8, lifting the 10-year nominal yield TMUBMUSD10Y, -0.16% to 2.95% from 2.01%, the resulting pain in the bond market hasn’t prevented the MOVE index from sliding. The 1-month MOVE index after spiking to 69.52 in Feb. 14 has fallen to 55.96, not far away from the decadelong low of 43.97 on Nov. 8.
Bond prices fall when yields rise.
“The proverbial “something’s got to give” is written all over it,” said Booth.
She blames bond-buying programs from major central banks like the Bank of Japan for suppressing volatility in Treasurys. Their purchases have capped the rise in long-dated bond yields, even as the Federal Reserve has made progress normalizing U.S. monetary policy, by forcing Japanese and European investors out of their own debt markets into higher-yielding U.S. government paper.
Rolling back the ECB’s quantitative easing should therefore accelerate the climb in Treasury yields, pushing prices lower, to set off turbulence in the bond market.
“The MOVE index should start closing the gap with real 10-year yields as investors transition from timing the end date of the ECB’s QE to timing the first Draghi rate hike,” said Booth.
Analysts expect the central bank to gradually taper its asset purchases starting from September, halting them altogether by as early as the end of this year. Economists’ forecasts for the timing of an ECB rate hike, the first since 2011, have vacillated between 2019 and 2020.