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What to Expect From U.S. Rate Volatility in 2020

What to Expect From U.S. Rate Volatility in 2020

(Bloomberg) -- This year will be remembered for a high level of policy uncertainty and fears of a U.S. recession that pushed up rate volatility from record lows.

The volatility roller coaster may only be repeated next year if circumstances lead to the market pricing further rate cuts. In this case, systematic short-volatility strategies will continue to underperform relative to recent years.

What to Expect From U.S. Rate Volatility in 2020
  • As suggested in the 2019 USD rates volatility outlook, systematic vol selling strategies suffered this year given the shift in monetary policy toward rate cuts from guidance for hikes in 2019, recession fears, uncertainty around the Fed’s reaction function and President Trump’s tweets.
  • In the scenario of the Fed on hold and stabilizing growth, the upper left of the vol surface (most sensitive to monetary policy) may remain near current lows and systematic sellers will be active.
  • Rates vol will be supported if trade tensions escalate and the manufacturing recession impacts the rest of the economy, with the current directionality of vol higher on lower rates.
  • The swaption vol skew remains in favor of OTM receivers across tenors, but the recent repricing of short-expiry payer skews on the de-escalation of trade tensions and curve bear-steepening suggests sentiment has moved toward a more neutral stance on duration.
  • While near-term optimism may see the vol surface trade sideways to slightly lower, 2020 may very well see a repeat of summer 2019, if indeed downside risks materialize.
  • The difference this time is that rates are lower following the 75bps of cuts in 2019, resulting in a smaller distribution of outcomes in the case of downturn, assuming the Fed won’t take policy rates into negative territory. Doing so would raise potential technical issues from settlement, create issues for money-market funds to U.S. Treasury issuing bills above par, as well as causing damage to bank profitability. This would limit the extent that vol could rise, given the zero bound and log-normal effect.
  • This leaves a narrow distribution of rate outcomes given: (1) zero bound on the left-side, and (2) a low natural rate and low inflation limiting the right-side, with the Fed probably needing to see inflation overshoot its target for rate hikes.
  • In any case, as always, focusing on the payoff function rather than relying on forecasting is key and taking opportunities that arise from change.
  • NOTE: Tanvir Sandhu is a global fixed income and derivatives strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.

To contact the reporter on this story: Tanvir Sandhu in London at tsandhu17@bloomberg.net

To contact the editors responsible for this story: Dana El Baltaji at delbaltaji@bloomberg.net, William Shaw

©2019 Bloomberg L.P.