Ruh-roh, Market Risks are Realigning with U.S. Treasury Volatility

Newsclips — July 23, 2018

Markets By Benjamin Breitholtz

Risks across asset classes are again aligning with U.S. Treasury volatility, meaning diversification will be difficult heading into the fall of 2018. The ECB, not recent talk of tightening by the BoJ, remains the world's most influential player. We continue to believe the ECB will have the right conditions for a 2019 hike as economic data rebounds.

Summary

Risks across asset classes are again aligning with U.S. Treasury volatility, meaning diversification will be difficult heading into the fall of 2018. The ECB, not recent talk of tightening by the BoJ, remains the world’s most influential player. We continue to believe the ECB will have the right conditions for a 2019 hike as economic data rebounds.

Comment

The chart below shows the rolling one-year correlation of major asset class returns to the U.S. Soft Economic Data Change index (Citigroup). 

U.S. soft (survey) economic data has lost its positive correlation to major asset classes this summer. Business T.V. anchors and their guests may continue hyperventilating about sky-high consumer and business sentiment, but markets are no longer wowed. Risk markets have shifted attention back to inflation and central bank expectations.

 

 

We are seeing waning correlation of asset returns to rate hike expectations for the Federal Reserve. Namely, the U.S. yield curve and dollar have given up higher positive correlations witnessed throughout the second half of 2017.

 

 

ECB rate hike timing has moved front and center with strengthening correlations to the U.S. dollar, 10-year note yield, and 2-year 10-year spread. Markets are struggling to price in a full hike by Draghi or his successor through the end of 2019. However an uptick in hawkish rhetoric would greatly impact the long-end of the U.S. yield curve.

 

 

The next chart shows the momentum behind realized inflation across major economies in the top panel and summed rolling one-year changes in developed central bank target rates in the bottom panel. This inflation momentum index is a composite of incoming releases relative to one-year averages. Above-zero index values indicate above-average momentum and vice versa.

The momentum behind inflation is again rebounding after slowing in early 2018. Not surprisingly, developed central banks have raised rates by a total of 175 bps over the past year when including shadow rates. Remember, shadow rates translate balance sheet changes (flow) into rate changes. Stronger inflation momentum keeps the door very open for the ECB to join the party in 2019.

 

 

Implied volatility across U.S. Treasuries is nearing all-time lows, chasing realized volatility into the abyss. Strong demand from overseas given the U.S. yield offering the highest developed 10-year yield is helping keep volatility low. 

But, risks are again oddly reconnecting to the MOVE index. The chart below shows the average three-month correlation of implied volatility across a broad swath of risk assets (equities, currencies, and commodities) to the MOVE index. 

Past similar periods of heightened connection to U.S. Treasury volatility have occurred during major geopolitical or market events like Lehman failing, the flash crash, and Brexit. We are again struggling to label higher correlations in the summer of 2018, just like the year prior. 

Our belief is the market’s expectations for inflation and the ECB are steering nearly all markets. Investors have yet to fully buy into the rising inflation story with expectations stuck near the best levels of 2017. Additionally, the recent swoon in Eurozone economic data has quieted ECB rate hike talk. However rebounding inflation momentum and Eurozone economic data will likely revive both the inflation and rate hiking storyline into the fall of 2018. 

Markets are clearly understanding this potential by aligning the embedded risks behind nearly all markets. There is currently nowhere to hide, just like mid-2017.