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In hindsight, we observed that releases of economic indicators or conduct of monetary policy over 2022 exhibited wide distributions. The standard deviations from the mean were high. US wage inflation data over H1 2022 or EU headline inflation data over H2 2022 were more spread out than consensus expectations. The surprise on central bank reaction functions is perplexing. The repetitive character of data and policy surprises translated into a persistent lift across rate, FX, commodity and equity volatility indicators. Can we extrapolate this higher volatility reality into 2023? Opening up the discussion on US interest rate volatility, expressed through the MOVE index or the US VIX equity volatility indicator, can add value in this respect.
The MOVE or Merrill Lynch Option Volatility index calculates the future volatility in U.S. Treasury yields implied by current prices of 1-month options on Treasuries of various maturities (2-years, 5-years, 10-years and 30-years). Implied volatility can be seen as a measure of the cost to insure against outsized interest rate moves, be they upward or downward. That measure currently sits at 113. A high was put in at 160 mid-October 2022. The future direction of the MOVE trade is dependent and correlated to the uncertainty around releases of economic indicators or monetary policy adjustments. The monetary policy uncertainty is fading as we are closing in on the end of the hiking cycle. The uncertainty around economic indicator releases is centered around ‘how much lower than consensus’ will the actual print come? That is certainly the case for US and EU headline inflation numbers, less so for core inflation readings. Base effects turn deflationary across good components. Energy base effects will become highly deflationary as of March 2023 as well as over Q3 2023. Across service inflation components, figures are flatlining or anchored around 2% annualised taken over the past 3 months. Effectively, our confidence is growing that the distribution of outcomes starts to converge as economic transition channels become less clogged. The wage inflation distribution remains wide. The last shoe to drop or the elephant in the porcelain room. Labour markets remain tight. But here as well, we tick alongside historically low unemployment figures. The distribution is skewed towards higher prints as the lagged effects of tight monetary policy unfold.
If anything, after an aggressive frontloaded developed market (DM) monetary policy tightening cycle over 2022, we can expect that market negative (across bonds and equity) economic indicator releases will decrease. Convergence in distribution implies tightness. Tightness equals less volatility. As we approach terminal FED or ECB policy rates over H1 2023, rate volatility might adjust to the downside. The average MOVE index reading over 2022 stood at 122. The average MOVE reading over 2021 printed 77. In the process of reaching terminal DM policy rates, in combination with emerging market policy rates which are already at a peak, US rate volatility might crumble… Break the 100 support and aim for the 80 level. When we take the MOVE series over the past 35 years, we notice that the MOVE index makes a low about 2 months before the FED starts to cut rates. Currently the market prices in a first cut early 2024. That would settle for a low on the MOVE index over Q4 2023. An environment where the MOVE trends to the downside over 2023 will be supportive for spread products. Expect IG and HY to thrive the moment rate volatility takes a back seat. Carry can crystallise. By the way, no need to see long rates adjusting to the downside. The moment 2-year to 5-year starts to stabilise mid-2023, yield curve inversion might rotate. To pencil in: probability of curve steepening led by the front end might rise and take effect over H2 2023.
The Chicago Board Options Exchange (CBOE) Volatility Index® (VIX® Index) is the centerpiece of CBOE’s volatility franchise, which includes VIX futures and VIX options. The definition by the CBOE goes as follows: “The VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPX℠) call and put options. On a global basis, it is one of the most recognised measures of volatility — widely reported by financial media and closely followed by a variety of market participants as a daily market indicator”. The VIX closed at 18.35 last Friday the 13th and averaged 21.67 over 2022.
The 30-year average for the VIX sits at 19.89. The 30-year average for the MOVE index is 91. Current US equity volatility is receding faster than rate volatility. The MOVE and the VIX indices tend to be closely correlated (0.80). One might expect the MOVE index to drop below 100 over the coming months, quarters. As such, policy and economic indicator surprises with a negative market impact become the exception over 2023 instead of the rule it was last year.
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