Riccardo Rebonato, Professor of Finance, EDHEC-Risk Institute, EDHEC Business School is specialist in interest rate risk modelling with applications to bond portfolio management and fixed-income derivatives pricing. He comments on yesterday FOMC & FED’s meeting minutes.
The equity markets heaved a sigh of relief after Chairman Powell’s words at the post-FOMC meeting conference, interpreting his remarks as an implicit assurance that (if needed) the policy of the Greenspan / Bernanke / Yellen ‘put’ will be continued under his stewardship. Matters are not quite as straightforward, however, for two important reasons.
- The darkest cloud on the economic horizon is the current trade war with China and Mexico. To the extent that President Trump feels he can count on the Fed’s support to ‘mop up the mess’ if the spill-over from the trade war turned ugly, this can embolden his stance, and bring about, via an aggressively hawkish negotiating position, the very need for monetary intervention. This gives rise to a dangerous positive feedback, which makes the monetary-cut prophecy more likely than ever to become self-fulfilling.
- If the problems faced by Chairman Powell turn out to be no more severe than an equity market wobble, with Fed Funds around 2.5% there is currently some room for conventional monetary actions such as cutting rates – actions whose value would be more talismanic than economic, but effective nonetheless. However, if the economy were to face a real headwind, the Fed would very soon have to resort to non-conventional monetary measures, such as QE. The two forms of monetary easing would have a very different impact on the shape of the yield curve, with conventional measures reducing, and QE intervention increasing, the current curve inversion. In Trump tweet style: “Mild downturn -> short rate down, long end little changed. Big downturn -> long-end down A LOT.” So, economic distress of different intensity could ring about qualitatively different changes to the shape of the yield curve.
These two linked observations (that the existence of the ‘put’ makes its exercise more likely, and that anything more serious than the economic equivalent of a common cold would require purchases of long-dated assets) can explain the current shape of the yield curve, with the 10-year yield stubbornly below yields at the short end of the curve.
As markets are by nature anticipatory, the inverted curve therefore already prices in the possibility of Quantitative Easing. However, since the darker economic scenario is far from being certain, the fall in yields at the long end if the need for QE did materialize would be much more pronounced than the current inversion.
In this environment, compensation for taking duration risk remains non-existing or negative – if anything, risk premia remain at the moment in negative territory (and will do so for the foreseeable future). This is only to be expected if Treasuries are more and more fulfilling an insurance role. After all, we pay, and don’t get paid, to have our house protected against fire.
Which also highlights that, today more than ever, if we want to understand the pricing of US Treasuries, these assets can no longer be analyzed as a self-contained asset class, but their pricing only makes sense in a portfolio context.
Riccardo Rebonato is Professor of Finance at EDHEC Business School. He was previously Global Head of Rates and FX Research at PIMCO. He also served as Head of Front Office Risk Management and Head of Clients Analytics, Global Head of Market Risk and Global Head of Quantitative Research at Royal Bank of Scotland (RBS). Prior joining RBS, he was Head of Complex IR Derivatives Trading and Head of Head of Derivatives Research at Barclays Capital. Riccardo Rebonato has served on the Board of ISDA (2002-2011), and has been on the Board of GARP since 2001. He was a visiting lecturer in Mathematical Finance at Oxford University (2001-2015). He is the author of several books, in particular having published extensively on interest rate modelling, risk management, and most notably books on SABR/LIBOR Market Model pricing of interest rate derivatives, as well as on the use of Bayesian nets for stress testing and asset allocation. He has published articles in international academic journals such as Quantitative Finance, the Journal of Derivatives and the Journal of Investment Management, and has made frequent presentations at academic and practitioner conferences. He holds a doctorate in Nuclear Engineering (Universita' di Milano) and a PhD in Science of Materials (Condensed Matter Physics, Stony Brook University, NY).