The real risk of rapidly rising rates

Russ discusses interest rate volatility and how to insulate the portfolio against it.

In less than one year the biggest risk to markets has flipped 180 degrees. Rather than worrying about a collapse in growth, today most investors worry about too much. In the process Treasury bonds have morphed from an efficient and reliable hedge to a source of risk.

As I discussed back in March, equities can live with higher rates. History demonstrates that stocks and interest rates often rise together, particularly when both nominal and real, i.e. rates after inflation, rise from unusually low levels, as is the case today. That said, a rapid rise presents a problem. For this reason, investors should pay attention to not only the level of rates but also their volatility. How rates rise may prove as important as the level they reach.

Brave new world

When markets buckled in early March, investors were reacting to the speed of the adjustment in bond markets. While the spike in bond market volatility proved short-lived, it reflected a dynamic that has not been resolved (see Chart 1). After years of assuming low and stable inflation, investors are questioning both the trajectory of prices as well as how the Federal Reserve will respond.

Chart 1
U.S. 10-Year Treasury 30-Day Annualized Volatility

Part of the challenge is this is the first cycle in which the Fed will be following their new approach, average inflation targeting (AIT). Investors are not entirely sure what to expect or how much to take the Fed at their word. Will they really be patient before raising rates and tightening financial conditions?

In addition to an evolution in central bank thinking, for the first time in years investors are struggling with inflation risks. In the near term, inflation calculations will be distorted by the low “base effect” from last spring’s shutdown. Longer term there is considerable nervousness regarding the largest fiscal package in generations and how that stimulus is being financed, i.e. central bank asset purchases. Finally, will the supply side of the economy be able to satisfy insatiable demand from newly flush consumers given a surge in commodity prices, stretched supply chains and (potentially) higher wages?

Given the uncertainty around both the pace of inflation and the Fed’s reaction function, we are seeing a rising correlation between bond and equity volatility. Since last November, the correlation between U.S. interest rate and equity volatility has risen from nearly zero to roughly 0.50. In less quantitative terms: What happens in the bond market no longer stays in the bond market.

If rate vol represents a growing risk, what are the best ways to insulate a portfolio? I would highlight three: cyclical equity expressions, volatility as an asset class and cash. As discussed previously, industrials, materials, financials and other cyclicals are likely to hold up best if rates spike. At the same time, investors can take advantage of lower volatility to use equity options to limit downside. Finally, cash, while boring, may prove the best risk mitigant.