Investors must see through a fog of emotion and bursts of news to place their bets on where inflation and the Federal Reserve are going next.
On March 10, just such a news burst upended their expectations. That's when the collapse of Silicon Valley Bank (SVB) led to near-record swings in treasury note interest rates which some experts think foretells a nasty recession, according to the New York Times.
Those expecting such a recession are in for a world of hurt.
That's my conclusion after interviewing two experts -- a Goldman Sachs managing director in charge of $240 billion in assets and an MIT finance professor -- who concluded that this volatility spike is of little long-term economic consequence.
While they did not agree on everything, their views align on the following:
What should investors do about this? The Goldman executive urges investors to move into a high-quality, diversified portfolio of investments and the MIT professor thinks that more people should exit non-interest bearing bank accounts and into higher-yielding money market funds backed by government securities.
Interest rate volatility grabs people's attention -- however, the experts I interviewed see that as noise in their analysis of what will move the economy, inflation, and interest rates.
Interest rate volatility, a measurement of daily swings in Treasuries, was recently at its highest since the 2009 financial crisis. Specifically, according to Investing,com, the ICE BofA/ML MOVE Index closed March 24 at "a whopping 145.25."
The recent behavior of the MOVE Index has significant implications. "A rise or fall in Treasury yields, which move in the opposite direction to their price, can ripple through to everything from mortgages to company borrowing -- affecting trillions of dollars' worth of debt," reported the New York Times.
Treasury yield volatility can be measured through historical data or by analyzing investor expectations. As Debbie Lucas, MIT Sloan School professor and director of the MIT Golub Center for Finance and Policy, says "Volatility is measured by looking at the data and calculating the standard deviation. Another way to look at it is implied volatility -- used in the MOVE Index -- which is taken from options prices and is more forward looking."
Three forces can work singly or together to increase treasury yield volatility. "Volatility increases when rates are rising, inflation is high, economic uncertainty is large, and due to positioning," says Alexandra Wilson-Elizondo, managing director and co-head of portfolio management, multi-asset solutions at Goldman Sachs.
Positioning has to do with how investor bets -- bullish and bearish -- are arrayed over time. "Positioning increases volatility when market participants have a strong view about what will happen to interest rates. Before [the FDIC took over SVB and Signature Bank], market participants saw better than expected economic data -- strong payroll trends in January 2023 -- would force the Fed to be more aggressive in raising rates," she says.
Most market participants were short interest rates, said Wilson-Elizondo. They borrowed treasury bonds and sold them on the expectation that they would drop in value because they expected the Fed to keep raising the Fed Funds rate. The investors expected to profit by buying back the bonds at a lower price to return the bonds they borrowed.
Those traders were caught in a short-squeeze, "As you get to late in the stages of the hiking cycle, the economic effect of higher interest rates start to come through. Market participants got caught in the fear of much higher economic uncertainty," she says.
That spike in uncertainty sent money into treasuries, which forced those who were short interest rates to buy back treasuries to cover their positions to limit their losses. "Positioning unwinds contributed to the extraordinary move in rates over the last few weeks. Levered players were removing shorts. Investors were underweight to benchmarks," Wilson-Elizondo explains.
Lucas also viewed higher uncertainty as the reason for the increase in volatility. As she said, "Volatility was up because of uncertainty about how long inflation will be high which is reflected in the interest rate," she says.
Lucas adds that she did not see SVB's collapse as evidence of problems that would overwhelm the banking system thanks to global central bank coordination. "I did not think that what happened with SVB would be important. With the Fed, European Central Bank and Bank of England raising interest rates; it was clear they all thought inflation was a bigger risk than the mismanagement of a mid-sized bank."
The increase in volatility could be due to changes in who owns long-term treasury bonds now and in 2008. "Back then, banks' treasury bond holdings were significant. Now, due to Dodd-Frank, banks hold fewer treasury bonds and the Fed holds more. This makes the overall market less liquid because there are fewer participants. So the SVB news had a disproportionate effect on volatility," Lucas says.
Investors have concluded that regulators effectively cauterized March's banking crisis. Wilson-Elizondo explains, "Volatility has declined from its March peak levels. The Fed has made moves to support the system. It has changed its policies -- [such as opening a window for banks to borrow from the Fed using impaired bonds] -- which is shrinking the distribution of outcomes. People are becoming more comfortable,"
Lucas credits regulators with doing a good job handling SVB's woes. "There was no reason to think that SVB's failure would be systematically risky. Not many banks acted like SVB. The Fed, Treasury and FDIC all used their emergency powers."
She does not buy the popular narrative about the Fed's failure to regulate SVB and votes for giving the Fed regulations to require banks to manage interest rate risk. "What happened at SVB was a classic case of a bank mismanaging interest rate risk," Lucas argues. "The Fed needs regulations to require banks to manage interest rate risks using tools such as interest rate swaps, futures, and options. The Fed should require this,"
Interest rates are just about at the level they need to be to get inflation under control.
"We think the higher interest rates are going to affect business decisions," Wilson-Elizondo says. "Corporate treasurers have to make decisions and they are trying to figure out the cost of debt capital. A higher cost of capital will constrain economic activity a bit."
Treasury yield volatility is less significant for the economy and the investment climate than the average level of interest rates. "Volatility is not telling us about the future of the economy. It's the average level of interest rates that will affect the economy," Lucas says.
What could increase the MOVE index in the next six to 12 months? Wilson-Elizondo says that the outcome of the debt ceiling negotiations and Japan's yield curve control policy in the face of rising inflation might boost the MOVE index. She expects the Fed to raise interest rates one more time this year.
There is no consensus on what the Fed will do after that. that "the rates market" currently assumes "approximately 100 basis points in cuts" in 2023.
Her business unit -- Multi-Asset Solutions at Goldman Sachs Asset Management -- is skeptical that the Fed will cut rates "given the continued tightness in the labor market," Wilson-Elizondo says. "We think the Fed's recent release of the Summary of Economic Projections illustrates the Fed's reaction function; their actions will not be solely driven by growth coming down," she says.
Pressure to increase wages is coming down because people are not switching jobs as much and when they do they are not enjoying the same pay increases. If the job market weakens -- say, 85,000 new jobs per month -- inflation would drop.
Wilson-Elizondo says thinks investors should recognize that 2023 is not 2008. "Some think we are going to dust off the 2008 playbook. 2023 is different. It is not about bank asset quality; it's a mark to market adjustment. The response in Europe and the U.S. is how quick it was. They learned a lesson from 2008. It looks like their aggressiveness ring-fenced the problem. The high cost of capital will mean tightening of credit."
Lucas adds the Fed should be patient and let its medicine work. "Inflation is transitory and will resolve itself over time. It was caused by expansive fiscal policy and monetary policy during the height of the pandemic. Inflation will unwind even if the Fed is not raising rates a lot. There is still a high level of savings being spent down. The Fed needs to be patient."
What should the average person do? "Banks are paying such low rates," says Lucas. "I am surprised more people don't take their money out an put it into a money market fund that invests in government securities -- which are low risk."
Wilson-Elizondo advises investors to think it is important to be diversified. "We are moving up in quality in fixed income, looking at high yield emerging market debt in Latin America. Investors should not go out on the risk spectrum -- they should be in the bond market, corporate credits, and diversified equities," she says.
She sees a significant change from last year: "In 2022, interest rates did not provide the traditional risk-off ballast to portfolios as the Fed was raising rates to combat inflation. This year, we think that rates will revert back to playing their defensive role in portfolios as we get to the later stages in the hiking cycle."
She also sees possible risk in other kinds of assets. "Past what has happened, we are looking at risk in commercial real estate and corporate loans -- we haven't determined if there has been an issue. We are also looking broadly at leveraged loans high in the capital structure, loans post-Covid, in clubby deals."
Not everyone is as sanguine as Wilson-Elizondo and Lucas. Greg Peters, co-chief investment officer at PGIM Fixed Income, told the New York Times, "The volatility is just extreme. How can one have confidence around investing, how does one put a stake in the ground and say they firmly believe something, when it is just so, so volatile? There is just so much uncertainty. The volatility creates volatility."
I think Peters is wrong -- stocks will continue their recovery as inflation works its way out of the economy and the Fed cuts interest rates.
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