Since the advent of modern financial markets, bonds have always had the reputation of being conservative – rather like an elderly family lawyer in a leather-bound chair frowning at more jumpy and excitable stocks. Bonds would never make you rich. However, they would provide you with a moderate, steady and dependable income.
This reputation was challenged in the 1970s and 1980s by Treasuries yielding more than 10%, in the wake of high inflation, and the explosive growth of the high-yield market. In the decades that followed, yields drifted down in parallel with inflation but investor excitement was maintained by a steady stream of capital gains as well as income. However, once monetary easing hit its peak in the days following the Great Financial Crisis, high-quality bond yields fell to levels that promised very little income and, at best, modest capital losses, assuming yields eventually recovered.
In the aftermath of the pandemic, massive government borrowing, inflation and Fed tightening have all contributed to rising bond yields. However, over the past year, despite a winding down of pandemic effects, steady economic growth, declining inflation and a pause in Fed tightening, bond volatility has persisted, with yields seeing sharp swings in both directions. Indeed, since the last Fed rate hike on July 26th of last year, the 10-year Treasury yield has ranged from a low of 3.79% to a high of 4.98%.
Statistically, this represents well above average volatility and it raises some important questions for portfolio construction. So it’s worth investigating why bond volatility has risen, where it might go from here and how investors should adapt to a world of more volatile bonds.
The Week Ahead
Before addressing these questions, let’s take a look at some key economic data and events for the week ahead:
The most important economic numbers will be contained in Thursday’s GDP report, which we expect to show annualized real growth of 2.2% in the first quarter. Looking under the hood, growth should be boosted by 3%+ gains in consumer and government spending and a surge in homebuilding. Business fixed investment, inventories and trade are all likely to detract from growth. However, the broad story appears to be of a very modest deceleration from the 3.1% GDP growth seen over the course of last year, with gains still running a little above the Federal Reserve’s 1.8% longer-run estimate of the potential growth rate of the U.S. economy.
Other data due out this week, including flash Markit PMIs, new home sales, monthly data on consumer income and spending, industry reports on light vehicle sales, durable goods orders and advance estimates on inventories and international trade, will help shape early estimates of second quarter growth. Overall, we expect these numbers to point to continued moderate economic expansion.
Turning to the earnings season, with 14% of S&P500 market cap reporting so far, the profit picture appears mixed, showing 70% of firms beating analyst expectations on EPS but only 46% beating on revenues. However, first-quarter corporate performance should be much clearer by the end of this week, since 158 of the S&P500 companies are set to report over the next five days.
Investors will also be very interested in the translation of earlier CPI data for March into the Fed’s preferred consumption deflator measures, due out on Friday. We believe that both the headline and core consumption deflators rose by 0.3% month-to-month in March with year-over-year gains rising by 0.1% to 2.6%, at the headline level, and falling by 0.1% to 2.7% at the core level. We believe that core inflation pressures are still easing but at a glacially slow pace.
Bond Market Volatility: What Isn’t Causing it
Just as financial commentators routinely say we live in uncertain times, they often claim that market volatility is unusually high. However, when it comes to the U.S. bond market today, this is actually true.
Looking at the Bloomberg Aggregate Bond Index, from January 2002 to June 2022, the average monthly return was 0.3% with a standard deviation, measured over a 24-month lag, of 0.9%. That is to say, roughly 2/3rds of the time, the monthly return was within a range of -0.6% to +1.2%. However, from July 2022 to March 2024, the standard deviation of monthly returns has been 2.0%.
In examining the causes of this volatility it’s easiest to start with what isn’t causing it.
First, it’s not due to increased volatility in economic growth. Over the past two years, the macro-economic outlook has, if anything, become steadier. The unemployment rate has now been in a narrow band of between 3.4% and 4.0% for 28 straight months, while real GDP growth appears to have settled into a steady, if somewhat strong, path.
Nor is it due to increased volatility in financial markets in general. This can be seen by the fact that equity market volatility has not risen nearly as much. Between January 2002 and June 2022, the standard deviation of bond market returns, measured over a 24-month lag, was just 27% of that of equity market returns as measured by the S&P500 total return index. From July 2022 to March 2024, that ratio has been 37%.
Finally, it’s not due to greater volatility in inflation expectations. The yield gap between 10-year nominal Treasury bonds and 10-year TIPS gives us a real time measure of the market’s expectation of inflation over the next decade. Measured on a monthly frequency, this expectation has stayed in a narrow band of between 2.18% and 2.41% since September 2022. In fact the standard deviation of inflation expectations, measured in this manner, has been almost 20% lower since July 2022 than in the prior 17½ years.
Bond Market Volatility: What May be Causing it
So what is causing higher volatility?
Three explanations come to mind:
First, it may be due, in part, to the huge volume of government debt that needs to be financed today.
20 years ago, Treasury debt in the hands of the public was $4.2 trillion, or 36% of GDP. 10 years ago it was $12.6 trillion or 74% of GDP. By the end of last month, it was $27.5 trillion or 99% of GDP. It is quite possible that this extraordinary level of debt is straining global capital markets in a way that just wasn’t the case 10 or 20 years ago, leading to more volatility. This effect may be being amplified by quantitative tightening which is having the effect of transferring Treasury ownership from price-insensitive buyers, such as the Federal Reserve, to much more price-sensitive private sector actors. Moreover, this effect could be further increased by the general decline in dealer balance sheets in response to regulation, even as the overall size of the global bond market has increased.
Second, higher short-term rates may be contributing to higher bond volatility. With a normal, upward-sloping yield curve, it is easy to assign investors to one of two well-defined camps: Those willing to accept some risk in return for better yields and potential capital gains, would invest in long-term bonds while, those willing to sacrifice return for safety, would stay at the short-end of the curve. However, with overnight rates well above five percent and long rates significantly lower, many long-term investors may be tempted to tactically switch in and out of the short-end of the market, adding volatility to bonds.
Finally, today’s volatile bond market may reflect the hyper-sensitivity of the Fed. Prior to the most recent inflation surge, Fed officials appeared to be relatively unphased by small overshoots and undershoots on inflation. However, today we appear to be in an era of zero inflation tolerance on the part of the Fed. Consequently, very slightly higher-than-expected March CPI numbers induced an immediate and violent reaction in the bond market, as futures markets almost overnight went from pricing in three full rate cuts in 2024 to barely pricing in two. Even if the inflation environment is relatively steady, a rise in the inflation-sensitivity of Fed policy could add to bond market volatility.
Bond Market Volatility: Consequences
Under any of these explanations, bond market volatility could be here for some time to come. There is no evidence that Washington is going to rein in fiscal deficits or that regulators will act aggressively to deepen liquidity in Treasury markets. While we still expect the Federal Reserve to cut rates later this year, yield curve inversion could persist for a further year or more. Nor is there any sign that inflation-scarred Fed officials are going to moderate their reaction to inflation news going forward.
If this is the case, investors may want to consider if their bond allocations are appropriate for the overall balance of their portfolios. They might want to consider shortening duration as a way to mitigate risk or generate alternative sources of income that may not be highly correlated to U.S. bonds, such as dividends on international stocks and interest payments on international bonds. And they may want to add alternatives as a way of providing stability and income to their portfolios. Most importantly, however, they should make sure they understand not just the general characteristics of bonds but also how those characteristics have evolved in what appears to be a new era of fixed income volatility.