29 Apr Fixed Income Perspectives
Voya Investment Management – Fixed Income Perspectives – April 2015
As spring tries to finally loosen us from an insistent Old Man Winter’s icy grasp, we’re witnessing another tug of war between the world’s major economies and its central banks. Despite ample signs of slowing economic growth in the U.S., Fed members and watchers alike have continued to talk up the need for near-term normalisation of interest rates. A mirror image is visible in Europe, where a nascent upswing in economic activity is being accompanied by a European Central Bank steadfast in its commitment to asset purchases through September 2016 to help the green shoots take hold across the region.
So what can we expect as these competing forces pull on either side of the macroeconomic rope? First, observed volatility of U.S interest rates will remain low; just a spring temperatures can have a hard time establishing themselves after a long winter’s chill, it will be hard for Treasury yields to rise in the face of prolonged softness of domestic data. At the same time, however, markets will find it difficult to mount a rally with the possibility of rate hikes still looming. U.S. interest rates, as a result, will continue to fluctuate within a fairly tight range, creating a lower volatility environment that is good for U.S. credit and negative convexity products like mortgages.
At the same time, the standoff between central banks and economic data – with a boost from the hedging needs of the pension and insurance sectors in light of rock- bottom interest rates – has engendered higher implied volatility (that is, estimates of future volatility) relative to the recent past. Any release in this tension – if the ECB decides to taper its QE ahead of schedule, for example, or if the Fed rhetoric grows decidedly more hawkish – could trigger a spike in observed volatility in interest rates and currencies. At the end of the day, the striking contrast between implied and observed volatility in the rates and currency markets suggests investors would be well advised to maintain exposure to risky assets while protecting against tail events.