Engineering the Volatility Out of the Market
What’s one of the most noticeable consequences of the Fed’s third round of quantitative easing (i.e. QE3)? It’s the stark drop in fixed income volatility. Look at the chart below, which demonstrates this point for the investment grade credit market. The blue line is the rolling 21-day realized total-return volatility for a Barclays Global Investment Grade Credit Index. The red line is Thursday, September 13, 2012 – the day the Fed announced QE3. As the blue line crosses the red one, you can see marked drops in the level and range of volatility.
Since QE3 was implemented, volatility has dropped – both credit volatility and interest-rate volatility. Actually volatility began dropping toward the end of August 2012, prior to the Fed announcement, when investors anticipated that the Fed was going to begin another stimulus program after the 2012 Jackson Hole meeting.
Not only has the level of volatility dropped, but (and this is the more interesting part) the volatility of volatility has also dropped. You see, the level of volatility seen in the markets isn’t constant. It changes. And how much the level of volatility changes and how fast it changes is the “volatility of the volatility.” The table below shows the range of the volatility in the Barclays Investment Grade Credit Index both before and after the Fed announcement.
It’s as though the Fed put the market on cruise control. Not only has the Fed given you big bumpers (or fenders) to absorb macro shocks, but it’s also moved in the guide rails, stabilizing the range of fixed income returns. Anecdotally that make sense; fixed income markets have not reacted to the swings in equities in 2013.
What does this mean to investors? Two points:
- First, the Fed has managed to support, and can continue to support, asset prices…even with very low yields.
- Bond picking, not beta, will dominate returns. Low yield and low volatility doesn’t mean “go out and buy the market.” In fact, that sort of “rising tide lifts all boats” trade is becoming less attractive, with lower total-return opportunities in fixed income. This means investors need to (or need their managers to) focus on opportunistic investing or bond picking to harvest gains.
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