Central banks are adding more ambiguity back into their reaction functions. This points to higher global rate volatility

After years of repression, rate volatility is beginning to rise. This is not only a reflection of greater macro-economic volatility, but – intentionally or not – is being hard-wired into the reaction functions of the world’s largest central banks in a drive to increase the “flexibility” of policy.

The Fed’s overhaul to its monetary policy framework, announced last September, will retrospectively likely mark a major turning point in the behaviour of yields and rate volatility.

Chart Source: Bloomberg, Macrobond and Variant Perception

As part of the new framework, the Fed now targets average inflation. The policy is inherently ambiguous, in the name of “flexibility” – the policy’s full name is Flexible Average Inflation Targeting (FAIT). No guidance is given as to how far back the Fed looks when deciding whether average inflation is too high or too low, or over what forward-looking period it will allow inflation to run hot or cold to make up for previous shortfalls or overhshoots.

After years of rate vol being repressed due to ever stronger forward guidance, the Fed’s new policy framework is inherently volatility inducing.

We are beginning to see this take effect.

 

Chart Source: Bloomberg, Macrobond and Variant Perception

In Europe, the rise in rate vol has not been as pronounced as in the US so far.

Chart Source: Bloomberg, Macrobond and Variant Perception

However, the ECB at its press conference earlier this month following its latest rate decision also introduced ambiguity to give itself more “flexibility”.

At the meeting, the Governing Council decided to conduct purchases under its PEPP program at a “significantly higher pace”, but then went through a number of verbal contortions to leave the market in the dark about how they would decide the exact pace of purchases.

 

Chart Source: Bloomberg, Macrobond and Variant Perception

The introductory statement stated, “We will purchase flexibly according to market conditions and with a view to preventing a tightening of financing conditions … “

In the Q&A, further ambiguity was added with the monthly purchases to be made under the quarterly decision on the purchase rate. The ECB’s president, Christine Lagarde, went on “ … it’s flexibility as how we use the overall envelop during the life of the PEPP” (emphasis added).

She added that the Council does not operate mechanically. Whether or not it was fully intentional to introduce this level of uncertainty, the drive for more “flexibility” in the ECB’s policymaking will increase the level of uncertainty and therefore bias rate volatility higher.

The world’s other major DM central bank, the BoJ, also desires to re-introduce more ambiguity back into policy.

Rate volatility in Japan for many has been depressed, and since the BoJ introduced yield curve control in 2016, rate vol has basically flatlined.

Chart Source: Bloomberg, Macrobond and Variant Perception

The BoJ is now looking at ways to increase yield fluctuations in the bond market. The BoJ dominates the JGB market, buying up a significant proportion of net issuance. At the moment, the BoJ targets 10y yields at 0% with range of around 20bps above and below the target.

Low volatility makes it easier for investors and traders to exploit trends, making it more difficult for the BoJ to defend its target, and increasing risks to financial stability. For similar reasons, China has intentionally added volatility to the yuan in recent years, as two-way markets are more difficult to exploit.

A rise in global rate volatility is fully consistent with the rise in macro-economic volatility. We can see the pandemic led to an unprecedented rise in the volatility of GDP.

 

Chart Source: Bloomberg, Macrobond and Variant Perception

And we are seeing a rise in inflation vol in the US.

Chart Source: Bloomberg, Macrobond and Variant Perception

As we have discussed in recently with clients, bond pricing is in a new regime. More macro uncertainty leads to higher term premium as bond holders demand extra compensation. Higher term premium means steeper curves, which leads to higher rate volatility.

Central banks, by introducing some ambiguity back in to their reaction functions, are really only allowing the natural order of things to re-assert itself. When central banking was less interventionist, more macro-economic volatility and more rate volatility went hand-in-hand.

All this marks a return to type for central banks. Inflation targeting and detailed policy meetings are relatively recent innovations, both pioneered by the RBNZ in the 1990s, then adopted by all other DM central banks soon after. Before then, the market had to look for signs to see what the central bank was doing in repo markets to infer any change to policy. Markets were used to dealing with more ambiguity.

We expect to see greater rate volatility in DM currencies in the coming months and years. Given forward guidance, we would expect to see this manifest itself more at the longer end.