Most of the commentary we read about Treasuries just now centers on yield levels. Will the 10-year Treasury stop selling off when it hits 3.25%, or is 3.5% the right number? Or will it be 3.6%? Opinions vary. But everyone has one, as the old joke goes…
Our two cents on the topic: we worry a lot more about yield volatility than any given level. Consider the following two scenarios:
- 10-Year Treasuries whipsaw from 3.0% to 3.5% from now through the end of 2018. On any given day, yields move by 5-10 basis points.
- 10-Year Treasuries sell off to 3.5% over the next 2 weeks, and then stay there (within 5 basis points, say) through the end of the year.
We would propose that the first (more volatile) setup is a lot riskier for global equities, corporate bonds and other risk assets than the latter. Coming off a long period of low rate volatility, markets are not conditioned to accept incremental yield uncertainty. Investors/traders would have to reduce their overall risk exposure, which would mean selling down long positions across the board. Not good. Capital goes where it is welcomed, and volatility is distinctly unwelcoming.
The other common narrative we read is that Treasury yield volatility is partly a function of the Federal Reserve’s sell down of its bond portfolio, aka “Quantitative tightening”. The story line here is that when the Fed was buying bonds from 2008 – 2014 bond volatility was lower than today because of their steady bid in the market.
You know our modus operandi: we don’t trust the market’s “memory” very much, especially about second derivative concepts like volatility. So we pulled the daily price record for TLT (the iShares +20 Year Treasury ETF) back to its start in 2002. Then we calculated the 90-day standard deviation of daily returns. Higher standard deviations mean higher levels of uncertainty over where long-term interest rates should be.
Our cynicism regarding the market’s memory of past rate volatility is merited. The past isn’t what the common narrative thinks. The data here:
- The standard deviation of daily price returns for long-dated Treasuries from 2003 – 2007 was 0.62%. Consider this baseline volatility for +20-year Treasuries pre-Financial Crisis and pre-Quantitative Easing. “Normal times”, in other words.
- From 2008 – 2014 long term Treasury daily price volatility rose 58% versus the 2003 – 2007 timeframe, to 0.98%. In other words, Treasury bonds were actually much more volatile when the Fed was engaged in QE 1/2/3 than pre-Crisis. Central bank buying may have dampened volatility, but the baseline was much higher than pre-Crisis.
- From 2014 to the present day, long dated Treasuries have seen much less volatility than during the days of QE. The standard deviation of +20-year Treasuries has fallen to 0.77%, 21% below those of 2008-2014. Not quite back to pre-Crisis levels of 0.62%, but close.
Myth-busting aside, here’s what you need to know about bond volatility right now: it is resetting to normal from abnormally low. Price volatility for long-dated Treasuries since the start of October shows a 0.72% standard deviation, right in line with the 2014 – present day average but above recent history (2018) of 0.61%. Yes, that happened to coincide with a forceful move through 3% on the 10-year. But in terms of volatility, it is nothing unusual.
Bottom line: this reset to normal Treasury volatility means equity market volatility will also move off its lows, so expect wider swings in stock prices from here on out. To end on a more comforting note, this reset is not a sign “The end is nigh” for the rally in US stocks. Getting back to “Normal” volatility in stocks and bonds is actually a healthy sign.