Evening Brief – 07.20.23
Following the July 25-26 FOMC meeting, where the market has already given the central bank the go-ahead to hike the Fed Funds rate another quarter-point, the Fed has a high bar to clear to raise rates again this year and an even higher bar to clear to cut rates.
Unless the Fed does something novel with its balance sheet reduction program, the remainder of the year is likely to be uneventful. Occasionally, the markets will move in response to the committee members’ message; however, unless the economic data is persistently negative or positive, they will attempt to remain on hold.
Consequently, the degree of volatility being priced into the bond market, as measured by the BofaML MOVE Index, appears to be excessively high in comparison with the degree of volatility being measured in the equities market by the CBOE VIX Index.
Bond volatility has increased in recent years and remains elevated. Throughout the majority of the Fed’s 18-month rate-hiking cycle, it has been twice the long-term average.
In the meantime, the volatility of the stock market has continued to decline, with the VIX trading at lows last seen in January 2020. Historically, the MOVE and VIX indices have had a tight correlation around 0.79; however, of late, this divergence has been wide and persistent.
Bond market volatility should gradually decrease relative to equity market volatility, in part because the depth of liquidity in the bond market is smaller than the liquidity in the equity market in relation to its size.
As the 2-year yield begins pricing in a lower Fed Funds rate a year or so in the future, the inversion of the 2s10s curve should diminish. A higher terminal rate and a longer time to get there may be priced in, however, for the 10-year yield.
The 2s10s curve has steepened about 25 basis points in the last week. Other parts of the curve, including the 3-month/10-year and 5s30s have also steepened.
Investing in bonds with higher real yields (yield minus implied inflation rate) is appealing if yields fall. The current real yield on the 5-year Treasury note is over 2%. When compared to the average rate of.55% over the past two decades and the average rate of .20% since 2010, it is quite generous.