Who ‘MOVE’d My Cheese?
In Spencer Johnson’s classic, “Who Moved My Cheese?”, the theme is simple yet profound: “Change is inevitable, and adapting is essential”. This concept resonates deeply with the bond markets today, where volatility has surged due to a confluence of geopolitical, fiscal and monetary factors. October was particularly eventful, marked by a sharp rise in bond yields as investors faced heightened uncertainties from key political and policy outcomes scheduled this week. The U.S. 10-year Treasury yields spiked by 50 basis points, with other developed market (DM) bond yields following a similar path. While equities in developed markets consolidated, bond markets reacted, with pronounced sell-offs in major DM bond indices.
Build-Up to the Election and the volatility
Since Harris’s nomination in July, bond markets have reflected the “Trump trade” in the lead-up to the election, with yields and the dollar index closely following betting prices of a Trump victory.
1. USD Dollar
The dollar index echoed strength, resembling the dollar rally that followed Trump’s 2016 win.
2. Treasury Yields
Yields have climbed, largely due to concerns over worsening fiscal health and inflation risks. Factors such as potential tariff impositions, retaliatory measures, proposed tax cuts to boost consumer sentiment, and an outlook for expansive government spending are all fuelling these expectations.
Recent yield trends suggest that the market’s anticipation of limited fiscal restraint and persistence of inflationary risks, are getting priced in to some extent, regardless of who wins the presidency.
October’s yield surge: Disseminating the MOVE Index Spike
The October 2024 data from the MOVE index, which tracks bond market volatility, reveals a significant increase in volatility compared to last year. When regressed against the 10-year yield, October 2024 data points lie above the trend line as well as above October 2023 levels. In October 2023, the U.S. 10-year yield touched 5%, reflecting widespread acceptance of the “higher for longer” interest rate narrative—a shift that became the new norm. This recent spike in market volatility and the yield movement suggest, investors are navigating an environment of heightened uncertainty led by numerous drivers.
Decoding Yield Components: Short-Term Rate Expectations and Term Premium
To understand yield volatility and trends, yields can be decomposed into:
1. Short-Term Rate Expectations
This reflects market expectations for near-term policy rates, which are largely aligned with central bank policy rate and anticipated rate adjustments.
2. Term Premium
This is the additional return investors demand to hold longer-term bonds, compensating for risks related to credit, liquidity, interest rates and other factors associated with holding duration. The term premium is especially sensitive to economic uncertainty, amplifying yield volatility as investors adjust their risk assessments.
Assessing Short term rate expectations
Monetary policy expectations continue to evolve, remaining closely tied to the Federal Reserve’s dual mandate of stable prices and maximum employment. So far, the Fed has managed a “soft landing,” keeping the U.S. out of recession. However, recent data—such as consumer spending, employment figures, and ISM indexes—show signs of slowing momentum.
Adding to this outlook, many proposed policy agendas from the presidential candidates carry potential inflationary risks. When regressed over the last years, regardless of political and policy changes, U.S. inflation (CPI) has on average trailed M2 money supply growth by about 24 months. The Fed’s restrictive monetary policy and rate hikes since 2022 have successfully curbed inflation this year. However, M2 growth, which dropped to -2.2% in January 2024, has since rebounded to 2.6% by September 2024. This resurgence in M2 growth could sustain upward price pressures, with inflation potentially rising again after a lag.
Core CPI could likely stay elevated, remaining above the Fed’s 2% target, which could keep the base yield curve higher and maintain wider yield-inflation differentials. Historically, similar wide differentials have occurred during periods of strong growth and policy adjustments, such as the robust growth phase of 2006-2007, expectations of policy tightening around 2010, the "taper tantrum" in 2013, and the Fed’s balance sheet reduction in 2018.
The scope for monetary policy adjustments depends on reaching a neutral rate (r*) that supports trend growth while closing the output gap to achieve target inflation levels. According to the HLW estimate, the output gap stood at a positive 0.1% for Q3 2024. In pursuit of a soft landing and with evolving growth inflation risks, markets have recalibrated expectations for monetary easing in H2 2024 and 2025.
Assessing Term premium sensitivities
The recent month-over-month yield spike of over 50 basis points reflects a notable increase in the term premium investors demand. In addition to the marginal increment in short term rate expectations, both the ACM and KW models from the Federal Reserve indicate a rise in term premium. This has stemmed from heightened debt levels, which challenge the market’s capacity to absorb supply and from policy uncertainty as investors struggle to assess shifting macroeconomic dynamics.
The increase in the underlying term premium and the associated volatility is driven by pricing risks linked to a wide range of uncertainties. These range from broader risks like a potential sovereign debt crisis to more niche indices tracking as ‘entitlement programs’ and ‘national security’.
Additionally, the Economic Policy Uncertainty index has shown significant widening in its components, particularly in "Trade Policy" (203.6) and "Fiscal Policy" (127.8). These trends largely reflect the growing bets on a Trump victory throughout much of October.
Directionally, the term premium tends to remain sticky for a quarter until greater clarity emerges on the underlying sources of uncertainty (structural measures/policy response). At present, the outcomes of the upcoming election, particularly with respect to the control of the House and Senate, will be crucial for the implementation of proposed agendas and their potential impact on yields. A Red sweep can further portend higher term premium with trade escalations as seen in the chart above.
Bond market embracing change: Higher term premium, higher volatility
Markets are currently pricing in a bear steepening of the yield curve, driven by expectations of calibrated monetary policy easing that affects the shorter end, while concerns over above-target inflation and increased debt supply weigh on the longer end. However, the backdrop of this political and policy transition is characterized by entrenched persistence of higher term premium and increased volatility, emanating from the multiple uncertainties and their correlated outcomes.