Following last Friday's abysmal jobs report and the FOMC minutes released Wednesday, the market's and Federal Reserve's take on the US economy remains a smooth mix at best; possibly even as an obfuscating cocktail. The single most heated event risk that has been and still is driving volatility in the markets remains the proverbial rate "liftoff" somewhere later this year.
It is high time we turned to the treasury market for insight instead of running around in circles chasing an old tail. First of all, readers should understand that the interest rates markets (which includes the money and treasury markets) are extremely adept to fluctuations in inflation and inflation expectations.
The rationale of a bond lies on the debtor (issuer of the debt security) paying the creditor (holder of the debt security) interest in the form of coupons on the principal. Bond prices are therefore extremely sensitive to interest rates - explaining the inverse relationship between interest rates and bond prices. In this note, we take a quick look into the treasury market. Eschewing other factors, it seems to us that treasuries are signalling the long awaited normalization of the broad economy.
Flattening Yield Curve Precursor To Liftoff?
The yield curve is a powerful tool but one that is not often utilized to gain perspective on the state of the general economy and sentiment amongst market participants. Here, we peer into the the belly of America's largest secondary market - the treasury market.
First of all, readers should understand that there are 11 different tenors of treasury securities issued by the US Treasury Department; they range from the 1-month bill (T-bill) to the 30-year bond (long bond). Each of these tenors carry different yields which constantly fluctuate as the market discounts new information. Generally and all else equal, the shorter the maturity of a bond, the lower its yield and vice versa; the market wants to be compensated adequately more for undertaking more duration risk.
As we link the market yields of each tenor of treasuries, we form the yield curve, which is almost always upward sloping. One exception as seen on the chart to the right was during September 2006 to July 2007 where the curve flipped; shorter maturity treasuries yielded more than longer maturity ones. The US economy was growing rapidly and economic prosperity was all the rage then. Stocks were also forming record highs, hence treasuries were not in demand. The sky couldn't be bluer then.
The shape and steepness of the yield curve more than just speak volumes about the state of the economy, they have consistently served as faithful stewards by being reliable messengers that hint of the future.
Harkening back to the days of 2004, the curve started to flatten massively because the Fed was on a steady path of hiking its target rate from the lows of 1% in 2003 to a ceiling at 5.25% in 2006. It was this 4.25% increase in rates over 3 years that brought the yield curve to a bizarrely gentle slope. It was to the extent that the curve became inverted in the latter half of 2006 to 2007 when the Fed Funds target rate stayed at 5.25%.
Although correlation is not causation, a growing and normalizing economy was the main reason for the Fed's tightening path in the former half of last decade. The committee's main concern would have been overheating prices in the form of high levels of inflation. The US economy was growing robustly and employment was nearing full.
As we take a top-down view on the US economy today, the only major sticking point is inflation and inflation expectations; oil prices had a huge part to play, but is still an external factor. Although we feel growth will decelerate in 1H15, this deceleration is likely to be a minor interlude and should not alter the secular tendency of tightening monetary policy after guiding the markets in that direction for more than 14 months.
The Fed has yet to hike interest rates, but the flattening of the yield curve seems to indicate that treasuries are already discounting a rate hike. It is apparent that the 1 and 2 year treasury notes are being sold the hardest while the longer duration bonds are not being treated similarly. It is this telepathy that the treasury complex possess which causes it to be highly endeared in our eyes.
The treasury complex seems to echo our sentiments - a flattening curve has historically correlated with economic moderation and positive growth. As said, the only concern is currently on the side of prices, a lot of which has to do with energy prices which policy makers have no direct control over.
Volatility Has Never Been More Volatile
Those that missed our primer on the ill-effects the end of QE had on the volatility markets, you are strongly encouraged to read what is truly a fascinating find: QE acted as a financial sedative to naturally volatile markets, now that it has worn off, the beast is now back with the harlot. Naughty, as some would opine.
Volatility itself in the treasury market has been relatively subdued. The same cannot be said for its convexity - vol of vol. The chart to the right clearly illustrates this point. Since QE3 commenced, vol of vol has increased substantially.
This observation ties in rather neatly with our prognosis that QE, or in fact all large-scale asset purchase programs, acts to smooth out returns on financial assets by suppressing volatility. In equities, and to a lesser extent investment-grade corporate credit, volatility risk premiums have fallen substantially under their long term averages as market participants are encouraged by the Fed's omnipotent backstop to falling asset prices to sell OTM put options.
ZIRP has had another effect on volatility of the short end of the treasury complex. As the chart above shows, volatility of the 1-month, 3-month, 6-month bill, and 1-year treasury note has been practically nonchalant to changes in risk appetite of the broader market. Not surprisingly because the Fed's target rate affects mostly money market securities (short duration risk). Conversely, when the Fed does actually embark on a rate hike, it is this band of the treasury curve that will experience the greatest flare in volatility. As for now, it appears the market is still comfortable with selling volatility premiums on the short end of the curve despite the countdown to the proverbial "liftoff" later this year.
The 1-year and beyond band of the treasury curve has however not experienced the halcyon utopia that the money markets have enjoyed. The volatility behavior in this part of the curve has remained relatively unperturbed compared to the pre-QE era. The peculiar observation is that when QE3 commenced, vol-of-vol surged while absolute volatility levels were squeezed into a tight range. This observation has never been seen before in all the data we have analyzed since the 1980s.
It honestly leaves us scratching our heads because we cannot, with the information we currently have, determine the exact reason for this queer development. Whether it was due to the flummoxing element as the markets gradually contemplated the Fed's tapering path and eventual realization that QE was going to end, or if it was the simple result of restless price action - yields neither went up or down by a huge amount; remains an open question. What we can say with good confidence is that as fall approaches, things will not remain as they currently are. It is in this type of environment, that the nimble stand to gain the most.