The high level of rate volatility raises two key questions. Firstly, volatility normalised gradually as rate policy took over from quantitative easing. Over a long period, the central banks’ grip on bond markets through asset purchase programmes suspended the usual market mechanism determining asset prices.
The confrontation of divergent opinions regarding the value of bonds was no longer possible due to the intervention by the central banks deploying their unlimited resources. The central banks’ interventionist financial domination effectively wiped-out rate volatility. During the crisis years, central banks’ forward guidance also ensured that rates were anchored at low or even negative levels, transferring market risk onto longer-dated maturities. The unusually steep hikes in base rates (50 or even 75 bps) and their frequency since 2022 have reestablished the historic term volatility structure.
Uncertainty over rates should be greatest among relatively short-dated maturities (close to two years) as long-term rates tend to average-out cyclical variations. An inversed volatility term structure is therefore the norm, which prevails again in early 2022. Lower volatility among long-term rates also reflects the fact that long-term bonds are more convex, meaning that at a given level of sensitivity, these bonds outperform shorter-dated maturities both in terms of rising and falling yields.
Secondly, volatility hierarchy in the leading financial markets appears to be at odds with historic risks. High-rate volatility contrasts with low volatility in credit, equities and foreign exchange rates. The asset which is considered risk-free (by default) has therefore become a major source of market risk. The paradox is that the heightened variability in the discount factor on risky asset flows has not been compensated by a higher risk premium on credit or equities. On the contrary, credit and equity volatility has decreased.
However, the monetary status quo in place since September 2022 is beginning to curb rate volatility. Over the longer term, financial volatility among equities and credit will probably resurge due to a hard landing in the economic cycle. In other words, a recession. Financial flows would move out of the most economically sensitive markets and rotate towards the least risky assets, including government bonds, anticipating monetary easing providing support to the fixed income markets.
When the economic climate becomes challenging, falling equity and credit security prices are generally accompanied by an increase in volatility, due to the “smile” profile, which characterises the asymmetrical relationship between listed volatility and equity and credit bond prices. For the usual volatility hierarchy to be reestablished, a normalisation of the economic cycle is therefore undoubtedly required.
