I haven’t written on the broad markets in a while – mostly because there really hasn’t been anything to discuss. We’ve had a selloff in fixed-income, but truthfully have just retraced the small rally that happened early in the year. US equities have been hanging out around the highs for a while, but have gone fairly quiet recently. If anything, markets feel stuck in the mud. It begs the question – what am I going to write about? I think we’re on the precipice of real volatility. Take a look at the following chart. The blue line is “1y10y interest rate volatility.” The numbers on the left hand side of the chart represent the statistical likelihood of interest rates moving – the higher the number, the larger the likely range on the 10yr rate. The red line is the VIX, which is a market estimate on future S&P 500 volatility. You’ll notice that there is a pretty tight relationship between these lines, but that lately there has been a divergence. It is that divergence that has gotten my attention.
I’ve written a few times on liquidity and credit risks inherent in the financial markets. With central banks around the world forcing liquidity into the system, these risks are real and terrifying. By lowering interest rates and forcing investors out of cash, the Federal Reserve has severely impacted capital allocations. While it is easy to focus on the credit risk caused by such a policy, what if the issue is with fixed-income allocations more broadly, i.e. the interest rate risk inherent in owning fixed-income? Over the last few years we’ve heard a lot of talk about fixed-income being a poor investment at these low yield levels. At the same time, money has poured into fixed-income ETFs of all flavors. Here is a chart of the shares outstanding of the meaningful fixed-income ETFs (the tickers included are: Broad: AGG, BND, Treasury: TLT, TIP, Credit: LQD, High Yield: JNK, HYG).
Even if I broke down each of those ETFs for you, you’d see that investors have continued to add to all forms of fixed-income despite low yields. When you combine this fact with the relative increase in interest-rate volatility depicted in the first chart, you can begin to see why I am starting to get nervous. Historically, banks have been able to step in to hold fixed-income on their balance sheet during times of severe rate moves – something that is unlikely today given post-2008 regulation.
How could there be a large selloff in interest rates without negatively impacting credit markets? If cash flees fixed-income and the Fed is still at or near zero on the cash rate, we could see a rebalancing of fixed-income into equities. This would help credit perform fairly well. That said, it is easy to be bullish at the top. It is also possible that a sharp rise in rates could upset all investors and cause equity markets to fall – but that would take a rapid rise to unexpected levels, say 3.5% or more on 10-year treasuries.
Over the last year, I’ve been more worried about a turn in the credit cycle than in a rising interest rate environment. Our loan book has a low duration and, more fundamentally, the loans we own are high enough in rate that the more important factor is the health of the economy. If our borrowers keep their jobs, they are likely to pay us back in full. That said, I think fixed-income volatility will be a precursor to equity and economic volatility. The economy has gotten used to cheap financing since the Fed lowered rates to zero in late 2008. Any move in fixed-income that suggests the central banks have lost control of the ability to keep rates abnormally low are a harbinger of more investment volatility to come.