Opinions, estimates, forecasts, projections and statements of financial market trends are based on market conditions at the date of the publication, constitute our judgment and are subject to change without notice. There can be no guarantee they will be met.
31 March 2023
A greater “range of motion” for bond market activity
The volatility of the past couple of weeks supports our base case of a recession, as tight monetary policy has caused stress in the banking sector while inflation persists. We assess recent central bank actions and their implications for fixed income portfolios.
Fundamentals
Central banks are in a challenging spot as they need to strike a balance between financial stability and price stability. Ahead of last week’s central bank meetings, the banking turmoil sparked a “to hike or not to hike” discussion, with market participants questioning whether the financial sector and the broader market could bear the consequences of another rate hike. All three central banks, the Federal Reserve (Fed), the European Central Bank (ECB) and the Bank of England (BoE), raised rates yet again. The Federal Open Market Committee (FOMC) increased rates by 25 basis points (bps), as anticipated by the market, and softened its forward guidance but is still awaiting further evidence of tighter credit conditions. Given the uncertainty around the outlook for the US banking sector we expect the Fed to pause rate hikes in the near team. The ECB hiked 50 bps and is still guiding towards further hikes; similar to the Fed it is requiring further evidence of tighter credit conditions before pausing. The BoE raised rates by 25 bps and maintains data-dependent forward guidance.
Quantitative valuations
Following recent events across the banking sector and the latest central bank hikes, investors have materially reassessed their expectations for the future path of interest rates. Prior to recent concerns about the financial sector, the market expected that central banks would continue to hike; it now sees rates as already having peaked and anticipates rate cuts by year-end. The front end of the curve, however, is particularly reactive to headline risks and has seen both a material repricing and a high level of volatility in the “repricing process” compared to long-term averages. For 10-year developed market government bonds, the long-term average of intraday changes is about 7 bps. We currently see averages of about 20-25 bps per day and have seen levels as high as 40 bps during peak volatility over the last couple of weeks in some parts of the market.
Technicals
In anticipation of an end to the recent rate hikes, broker positioning monitors indicate that investors have moved towards a more defensive stance and started to add duration and steepeners to portfolios. While investors are searching for indicators that the acute phase of stress has cooled down, volatility remains high: the MOVE index, which reflects rate volatility, is currently at levels only seen in 2020 and not far from levels experienced in the global financial crisis (GFC) in 2008. The current volatility in the rates space is also notable relative to other sectors. During the GFC in 2008 and 2009 rates and equity volatility moved together, while in late 2022 and early 2023 they are diverging; rates volatility has remained at high levels while equity volatility has declined. The dynamic is similar when comparing rates volatility to the credit and currency (FX) markets. During the 2010s, the low levels of interest rates and quantitative easing programs from central banks supressed volatility, to some extent. With more normalised monetary policy comes a greater range of motion for the rates market.
Volatility in global rates is at 2008 highs while equity volatility has declined
Source: Bloomberg. Data as of 30 March 2023. An average of US and European markets is used as a measure of global volatility. Equity volatility is an average of the VIX and V2X indices; rates volatility is an average of the MOVE and EUR swaptions indices.
What does this mean for investors?
With the market still making up its mind on what’s to come, we think that volatility is here to stay. As financial conditions tighten, we are positioning for a recession and are making use of backups in yields to add duration to portfolios. In addition, we highlight the importance of security selection as dispersion between the strength of issuers increases in this type of environment. Investors should focus on high-quality names and be selective when entering into riskier parts of the market.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors
include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations
is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors
are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum
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