Recap 2014-10-22: A Perspective on Yields & Vol


I think long term US yields are close to fair value here. 3.0% has been my bogey for 30y yields since 1Q. That view is now seems to be supported by positioning data, which has reverted from very short readings and is now showing readings about 1 standard deviation above neutral, according to JPM:

It is interesting that people were focused on the CPI print today, especially since the market talk last week was ‘growth fears.’ (growth leads inflation – so if there is uncertainty about near term growth, why should it matter what last month’s inflation was?) That hasn’t happened in a very long time. The focus may be related to the fact that despite the move in equity markets, long term US inflation break evens remain at levels not seen since 2011. We can spend a very, very long time discussing why that may be, but for simplicity I will just note that a decline in inflation uncertainty – i.e. coming as a result of higher structural oil supply – will itself decrease inflation expectations, given where they are relative to zero. I’ll reiterate that 1) I don’t think the move is a fluke and 2) declines in inflation expectations are quite bullish for the present value of financial assets.

Like yields, rates volatility is very low relative to history. Harley Bassman, now at Pimco, published a great piece on it recently, and in particular noted the divergence between the steepness of the curve and rates vol. The consensus view is that with the end of QE and the Fed in play, Vol should be higher across all asset classes. And quite certainly, rates vol will rise over the cycle. But that is quite different from the contention that it should be higher now, or in the near future. That is a point that Bassman likely knows well, since he made the same point a year ago. The advent of forward guidance & increased transparency means that the Fed is less likely to pull Volcker like surprises. And given the lower level of terminal rates, arguably the long term average will be lower than that of the past as well. (i.e. if the Fed will stop hiking at 4% rather than 8%, long term rates volatility should fall to reflect the narrowing of the probability distribution) A fundamental model of the MOVE index (rates volatility) suggests that current levels are quite rich, even though they are depressed relative to history. Model outputs for equity volatility are similar.

My point is simply that despite consensus views to the contrary, it is not obvious to me that both yields and volatility should be higher in the near term. IMO, the decline in both are driven by fundamental underpinnings, and we are unlikely see the same averages as the past. This suggests some interesting option plays in rates space, as Bassman noted.

That segues to the dollar. The dollar move has closed tracked rate differentials over the past few months. However, rate differentials have since turned, but EURUSD has not.

In addition, many macro tourists are touting long USD trade ideas now. After a 15 big figure move in 5 months. And Paul Tudor Jones says the move may be over! I espoused the USD structural bull market view a couple months ago, so I sympathize with the tourists. But now does not seem like the best time to be pushing that bet – despite the retracement, it seems like no one is bearish the USD anymore.


  • BoE Minutes: The unemployment rate had fallen by a little more than expected in the most recent data. Despite this, the labour force participation rate had also fallen and it was now estimated to be a little further below its potential level than previously thought. Analysis by Bank staff suggested that the output gap, while continuing to fall, was estimated to be slightly larger in the second half of the year than had been previously expected.
  • BoC kept policy unchanged as exp, but Poloz hinted that they may be lowering their estimate of potential GDP
  1. most of the sectors expected to lead the non-energy export recovery still have some excess capacity. Our Business Outlook Survey (BOS) interviews indicate that while companies plan to invest in new machinery and equipment, few are planning to expand their capacity, at least so far.
  2. Each October, we do a full analysis of the determinants of potential output, and its future trend. We have done so in this MPR, but in future we will do this in every MPR.
  3. The reason this is important is that in such longer business cycles, the restructuring or closure of firms reduces potential output while creating permanent job losses. This means that the output gap can appear smaller than the labour market gap, which is our current situation. This difference persists until the rebuilding phase of the recovery I discussed earlier, after which the excess capacity measures eventually converge.
  4. The neutral rate, too, is uncertain. We estimate that it now lies between 3 and 4 per cent
  5. After weighing these considerations, it is our judgment at this time that the risks around achieving our inflation objective over a reasonable time frame are roughly balanced. Accordingly, we believe that the current level of monetary stimulus remains appropriate.
  6. Some interesting charts from the MPR:

Canada Retail Sales declined -0.3% vs 0.0% exp. The ex auto measure also fell -0.3% vs +0.2% exp

US CPI was stable at 1.7% vs 1.6% exp. The Core measure was stable at 1.7% as exp

DoE Oil Inventory Report showed a large rise of 7111k vs 3000k exp and 8923k prev. Gasoline and especially Distillate Inventory builds were also higher than expected

Australia CPI declined to 2.3% YoY in 3Q as exp vs 3.0% prev. The Trimmed Mean measure declined to 2.5% vs 2.7% exp and 2.9% prev, but the weighted Median measure was broadly stable at 2.6% as exp.

according to Spanish news agency Efe at least 11 banks from 6 European countries are set to fail the stress test (note that 130 banks are being subject to the tests). Reuters

ECB governing council member Luc Coen said there are no concrete plans to buy corporate bonds but he acknowledged that this could be an option. "If we limit ourselves to buying covered bonds and asset backed securities there is a risk that we would pay too high a price. We can prevent that by also buying corporate bonds” – Reuters

the drive to standardize tax policies across Europe has already ensnarled Ireland and now Luxembourg is on the firing line. The WSJ discusses how some Luxembourg tax structures are coming under attack from Eurozone officials. “Regulators say no European country has been as aggressive as Luxembourg over the years in using tax breaks and confidentiality to lure international businesses”. WSJ


  • Wed: New Zealand CPI, Japan PMI, China PMI
  • Thu: EU PMI, UK Retail Sales, Jobless Claims, FHFA House Price Index, US Markit Mfg PMI, EU Consumer Confidence
  • Fri: German GfK Consumer Confidence, UK 3Q GDP, US New Home Sales
  • Mon: German IFOUS Markit Service PMI
  • Tue: US Durable Goods Orders, Consumer Confidence, New Zealand Business Confidence

2 thoughts on “Recap 2014-10-22: A Perspective on Yields & Vol

  1. Very strong point about no one being on the other side of the EURUSD trade and the narrowing yield differential. But do you think that portfolio flows could push the dollar higher? If growth in the eurozone remains weak and shorter dated yields below zero (helped by ECB), asset allocators would probably move more of their money into the US financial assets.


  2. Could happen, certainly. The yield difference argument is probably already captured by the yield differential relationship. Flows could also occur in equities space, but given the relative performances recently, that doesn’t seem likely. Net FDI flows could be another factor. But with the EUR already weakening as much as it has, it seems likely that there will at least be some positive impact on its already large Current Account surplus.

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