Let me set the stage. The price of oil is up over 7.5% in the past month. We’re looking at the beginning of the end of quantitative easing in the United States and the consequent rise of interest rates. Escalating mortgage rates could frighten potential homeowners back into renting. We have a raging (as well as politicized) debate as to who should be our next Fed chair. Financial markets and currencies from many emerging economies are hitting the wall. The U.S. government is about to enter a protracted debt-ceiling debate. And, as if this is not enough, we now have a possible U.S. intervention in the Mideast that could rattle worldwide financial markets. The winds of war may breach any national border.
With this backdrop in mind, the question we must pose is this:
Setting aside the moral, ethical, and political conundrums of a U.S. intervention in Syria, how should we expect financial markets to react when conflict in the Mideast flares up? Read more
We can give three simple reasons to support the use of volatility products to hedge tail risk in fixed income portfolios. First, equity volatility and bond prices have a strong conceptual link. If you think of a corporate bond as functionally equivalent to a risk-free asset (like a Treasury bond) plus a short put option on the issuer’s assets, then the additional yield you receive above the Treasury rate (a.k.a., credit spread) can be thought of as compensation for the sale of that put option. When equity market volatility jumps drastically (as it does during a tail-risk event), the implicit liability from the short put position increases in probability. In a nutshell, the value of bonds will fall as market volatility (yes, even equity market volatility) rises. Read more
With the recent increases in U.S. Treasury bond yields, some are decrying the situation as a disaster-in-the-making for Asian economies; however, we don’t subscribe to that view completely. While the levels of yields are indeed important, they’re only part of the picture; the pace at which yields change is also a critical factor. A gradual increase in the yields to 3% (the point at which we’ll cross the Rubicon, according to several commentators) wouldn’t spark a crisis for economies that have benefited from capital flows over the last few years – in effect, it would imply a further 50 basis point (bps) move higher in U.S. Treasurys from current levels, which isn’t necessarily a huge change.
The whole issue revolves around something called the “carry trade.” In its simplest form, that’s when you borrow money in a place with low interest rates, and invest that money in a place with higher interest rates in an attempt to capture the spread, or the difference between the rate levels. The worry is that with the yield differential between Treasurys and Asian government bonds diminishing, investors will abandon Asia and pile into the U.S. Read more
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.
Anyone who follows the financial news has probably heard the terms “alpha” and “beta” in relation to investing. However, it’s rarely explained how important they are when it comes to making investment decisions.
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