Bond-market titans BlackRock Inc., Pacific Investment Management Co., and Vanguard Group Inc. are warning that recent violent swings in US Treasuries are only the beginning of a new era of volatility that’s here to stay until central banks conquer inflation.
A closely watched measure of turbulence in the world’s biggest bond market has already risen to levels last seen during the Great Financial Crisis. A bevy of risks has buffeted money managers in 2023, from banking-sector tumult to the debt-ceiling standoff, capping two years of wild movement in interest rates as the economy emerged from the pandemic.
For these fixed-income powerhouses, who manage trillions of dollars between them, this is the new reality investors will have to grapple with, potentially for years to come. They point to the Federal Reserve’s switch to inflation-fighting mode after buying up trillions of dollars of debt since 2009 to support growth — an effort that helped depress volatility and spur the seismic shift toward passive investing in bonds.
“We’ve gone back to the future – back to normal — which makes sense as the Fed has taken its thumb off the scale,” said Harley Bassman, who created what is now known as the ICE BofA MOVE Index, a widely used gauge of implied volatility in Treasuries, while at Merrill Lynch in 1994. He’s now at Simplify Asset Management Inc.
There are other forces at work fueling the choppier Treasuries trading, notably impaired market liquidity as big dealers operate under a stricter regulatory regime. But the primary catalyst remains the overarching debate around how central banks will navigate a challenging combination of weaker growth and still-high price pressures.
It all boils down to just how far the Fed will be able to cut rates during the next economic slowdown and whether policymakers may need to hike again — after their most aggressive tightening cycle in decades — should they fail to get inflation back down to their 2% target. Determining the longer-term trajectory of inflation will be crucial for investors to solve that puzzle.
“It’s the volatility of inflation that matters,” said Luca Paolini, chief strategist at Pictet Asset Management.
Amid deep-rooted forces like labor shortages and deglobalization, he sees a greater risk of inflation disappointing those who expect it to return to target, leading to “a decade of higher rate volatility.”
Time to Shine
Divining the path of inflation is obviously crucial across the economy, from corporate managers who set salary levels and oversee procurement to the average American saving for retirement.
In fixed income, the new backdrop raises the stakes for active managers, who saw their market share dwindle during a lengthy period of modest growth and below-target inflation that deadened fluctuations and rewarded investors for taking a passive approach.
Active bond managers’ performance this year vindicates the notion that increased volatility provides a profitable trading backdrop: Some 77% of funds with assets over $1 billion are beating the Bloomberg USAgg Index, up from 51% last year and an average of 65% over the past five years.
Flows into active funds have also turned positive in 2023. They’ve attracted about $8.3 billion this year through April, after a $525 billion exodus last year, data from Morningstar Inc. show. Granted, that still trails the $92 billion entering passively managed funds, which also drew $193 billion in 2022.
“There are opportunities for active investors because central bank reaction functions are in flux,” said Roger Hallam, global head of rates at Vanguard Asset Management. “Investors need to judge how long the Fed is on hold, and whether the next move is a hike or a cut.”
To be sure, New York Fed President John Williams said he sees signs that some aspects of the rates environment are back where they were before the pandemic. In remarks Friday, he said there’s no evidence the outbreak has ended the era of very low rates seen before the crisis.
But in Pimco managers’ discussions on markets and investing, one hot topic has been the potential for higher rates of volatility for years to come.
“The Fed funds rate won’t be as volatile as the past year, but higher inflation means the volatility around the Fed’s main funds rate is higher,” said Michael Cudzil, a senior portfolio manager at Pimco. “It is possible we do go back to a low rate-low inflation world, but after weighing all the probabilities we assign stronger odds of higher volatility in the next decade.”
Among major implications, “just being a passive index player will not allow you to take advantage of dislocations in markets,” and many assets are likely to cheapen in an environment of higher realized volatility, he said.
That kind of outlook also resonates with Jean Boivin, head of the BlackRock Investment Institute.
Higher prices in the production process loom from forces such as aging populations and the breakdown of global supply chains, leaving central banks with a tough choice, said the former Bank of Canada deputy governor.
They “either stabilize inflation and bring it back to target quickly, by generating a meaningful recession, or you tolerate more inflation to avoid the damage,” he said. “Markets are still expecting the Fed quickly turns to an easing cycle, and until that is reconciled, rate vol stays high.”
For investors, it all means they “will need to be active in revisiting their portfolios, and it will be more about relative value,” Boivin said.
Markets Diverge
While the ICE BofA MOVE Index remains well above its five-year average, measures of equity and currency volatility are more benign. The divergence reflects how the prospect of Fed rate cuts — which the market expects by year-end — is helping contain the dollar and bolster the outlook for equities. The risk for those asset classes is that rates traders are correct in anticipating more violent swings ahead.
That’s the scenario that Bassman at Simplify Asset Management envisions.
He co-manages the roughly $240 million Simplify Interest Rate hedge ETF, (PFIX), which aims to offer a hedge against a sharp rise in long-term rates. The fund is up about 4.4% in the past three months, paring its drop this year to around 5.6%, data compiled by Bloomberg show.
Bassman’s assessment is that the market is unlikely to get the rate cuts it anticipates, barring a severe economic downturn or some geopolitical shock.
“This is why the rates market is just ping-ponging back and forth and the equity market is just on the sidelines at a tennis match watching the back and forth,” he said. “They can’t figure it out.”
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