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Stability is Destabilising

As we often note, there is an intimate link between liquidity, volatility, and leverage. Put differently, long phases of low volatility can lead to excessive credit accumulation and balance sheet leverage in the financial system. The paradox of the “Sharpe-ratio” (or value-at-risk) approach to managing exposure in most of the industry is that long periods of stability encourage market participants to take on more leverage when liquidity is plentiful. As a result, participants become short convexity and phases of stability lead to episodes of instability. Unfortunately, most of the 10-year market veterans in the industry have only experienced the low interest rate and low inflation regime until recently.

The rapid and emotional or non-linear increase in yields since 2022 has been catastrophic for investors in long duration fixed income. The drawdown in TLT or the long bond ETF has been over 50% which is comparable to the 2008 bear market in equities. The rise in Treasury yields and rates has also contributed to US dollar strength and a tightening in broad financial conditions. The big picture question is whether the episode has been adequately priced?

The fair value for the long bond is the future expected short rate plus a term premium and a risk premium for inflation. While the fixed income mathematics is more complex, a simple anchor for the 10-year Treasury yield has been the 5-year moving average of the Fed funds rate which incorporates the consensus beliefs and behavioural (anchoring bias). Clearly the current Fed Fund’s rate has moved much higher compared to the 5-year average and policy conditions probably have moved to a restrictive level (chart 1).

Another way to frame or anchor the fair-value of the 10-year Treasury is the trend in nominal GDP. That suggests the recent move in long dated yields has been warranted and that an even larger rise in yields might be appropriate (chart 2). However, on the positive side, nominal GDP has started to decelerate from the cyclical peak, policy rates have become more restrictive, and the excessive fiscal impulse is unlikely to be repeated looking forward. As we have noted recently, leading indictors of the labour market also suggest that final demand and inflation pressure has started to slow. Of course, Hayek’s observation on volatility is not simply a financial market concept. It is also linked to economic volatility or variability in nominal GDP and inflation. Long periods of stability also encourage households and corporations to take on too much leverage.

From our perch, and in contrast to some of the Fed speakers this week, the increase and level of fixed income yields is not at all “perplexing.” Trend nominal growth has been high, the budget deficit (and fiscal thrust) has been extremely large given an economy operating at full employment. In that context, the nominal and real funds rate is entirely appropriate. The challenge for markets is that compensation for risk or risk premium on a range of assets is too narrow relative to duration-free short-dated Treasury bills. While the total yield package is 6.25% on the US Investment grade index, the spread compensation is low relative to risk free rates. Risk premiums in credit and equity are probably too low if or when there is another major episode of volatility (final charts).

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