Expected interest rate volatility has fallen 28 points so far this year
The financial markets are predicting less volatility in interest rates during the coming months—which, if true, could also mean a smoother road for stocks, bonds, and investors’ portfolios overall.
To see why, check out the chart below. It shows the amount of day-to-day volatility that investors expect to see in the two-year Treasury yield over the next six months on average, as measured by the two-year Treasury price volatility. The key takeaways:
- Expected yield volatility soared in 2022 as the Fed hiked rates, peaking in September and staying elevated. At year-end, investors were looking for the yield on the two-year Treasury note to fluctuate by nine basis points per day, on average. As the chart reveals—and as we highlighted in our fourth quarter report — movement of that magnitude for a short-term Treasury note would be extraordinarily volatile.
- Recently, however, those volatility expectations have fallen sharply—down 28 volatility points (vols) so far this year to their lowest level since March 2022. Back then, the Fed had just raised interest rates by 25 basis points, on its way to a total increase thus far of 425 basis points. Investors now expect the two-year Treasury note yield to fluctuate by seven basis points per day, on average, over the next six months.
Source: Bloomberg, as of 01/27/2023
Here’s why that’s a big deal. Stocks’ valuations and expected returns are determined largely by the yields on risk-free assets such as the two-year Treasury note, which is backed by the full faith and credit of the U.S. government. So if investors think the yield on that seemingly stable, risk-free asset is going to fluctuate wildly—as they did last year—it becomes virtually impossible to value stocks (and many other assets) with any degree of confidence.
The upshot: As volatility expectations come down to more historically normal levels, investors gain much-needed clarity about the likely direction of stock prices going forward—and should become more willing to buy stocks and other risk assets.
In fact, it’s already happening: The S&P 500 TR Index is up 14.3% from the lows of last year as of January 27, 2023.
That said, risks remain. Expected volatility will need to fall below 80 vols to be back in the range of normal (approximately five basis points per day). The good news for investors: It’s moving in the right direction.
This commentary is written by Horizon Investments’ asset management team.
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