Rates Spark: The burning question

Market gyrations this week should serve as an illustration that recent spikes of volatility, were not isolated events but a sign that rates markets have entered a more volatile phase. This fact itself warrants its own conclusion. In a market where realised volatility is on the rise, it is only natural for investors to question the size of their exposure to low yielding products. The reasoning is as follows: for an asset to be valued fairly, risk must be compensated by higher returns. In the case of low yielding government debt, if there is a sustained increase in volatility, then investors would supposedly only be willing to buy it for higher yields.

The burning question is: how long will central banks shield markets from volatility

This theory can often be put to the test by central bank intervention, primarily bond purchases skewing lower the ‘compensation’ offered for investors to take on an asset’s risk. The burning question is: how long will central banks shield markets from the volatility that should normally occur when the range of possible economic outcomes is as wide as it is currently? Judging from the Bank of England’s urgency in signalling a policy tightening in the face of inflation fears, the answer seems to be ‘not a lot longer'.

Indeed, there are differences from one country to the next, but inflation fear is a global phenomenon and the action of one central bank can precipitate that of another. Typically, it is the largest of them, the Fed, forcing the others’ hand, although it could be said that the European Central Bank and Bank of Japan actions have also had a noticeable effect on rates markets globally. In any case, the Fed currently looks like a beacon of stability with its tapering timeline running until mid-2022, acting as a dam against the market pricing hikes before the latter half of 2022.

The Fed currently looks like a beacon of stability with its tapering timeline

Much then, depends on whether the market comes to doubt the Fed’s guidance. If it does, then the current phase of higher volatility can continue in rates but does not have to spill over to other markets. Calm in risk assets also means that government bonds fail to benefit from much of a safe haven bid, and their yields continue to climb higher in line with the progressing recovery. If, on the other hand, doubts spread about the Fed’s ability to manage a smooth exit from exceptional level of accommodation, then risk sentiment could deteriorate rapidly, and we would be back to square one.