What Investors Need To Know About the Surge in Interest Rate Volatility

Executive summary:

  • Interest-rate volatility on shorter-duration assets is running near historical highs, even as rate changes begin to level off.
  • Interest-rate volatility typically coincides with strong fixed-income returns. However, elevated volatility can be a signal that rougher times are ahead for the Treasury market and passive investments.
  • We believe the current environment offers several exciting opportunities for active fixed-income managers.

Since interest rates started rising in 2021, investors have closely followed changes in interest rates: Taking bets on what will be announced at an upcoming Fed meeting or expressing shock at the latest mortgage rate are common discussion topics today versus three years ago, but are interest rates more volatile? And as rate changes start to level off, is volatility leveling off too?

What's the difference and why should it matter to investors?

Interest rate volatility refers to the degree of fluctuation in interest rates over time, while changes in interest rates refer to the actual movements in interest rates. We leverage two standard measures of interest rate volatility: 1) the MOVE Index, a market-implied measure of Treasury bond volatility, and 2) standard deviations of Treasury futures contracts of different maturities. Decomposing the overall MOVE Index into components such as 2-year, 5-year, 10-year, or 30-year allows us to look at what part of the curve is the most volatile. What's interesting for investors is that interest rate volatility can be high even if the changes in interest rates are relatively small, and vice versa. Currently, we are experiencing a period where changes and volatility are decoupling: the rate of change is slowing but volatility continues to rise.

What does that mean for investors? At the most basic level, volatility matters to investors because it increases risk and the chance of loss, especially for investors who need to sell bonds before maturity. Interest rate volatility impacts different bonds differently, and investors can benefit from being aware of these differences. But it's not all bad news. As active investors, this type of environment also presents more opportunities. From our vantage point, this backdrop underscores the importance of partnering with a skilled OCIO provider who has extensive experience in risk management, including the ability to identify and exploit both risks and opportunities.