Bond Market Volatility Echoes Great Recession: Will Central Banks Give Up On Interest Rate Hikes?

Bond market volatility has been through the roof recently due to increased banking sector stress and investor uncertainty over the Fed rate path.

The ICE BofA Merrill Lynch U.S. Bond Market Option Volatility Estimate (INDEXNYSEGIS: MOVE), commonly known as the "VIX" for bonds and a widely used measure of the implied rate volatility in the U.S. Treasury market, has spiked this week to levels not seen since December 2008, when the financial markets were at the height of the Great Recession after the collapse of Lehman Brothers.

MOVE Index, Chart: TradingView

The sharp increase in the MOVE index reflects the extraordinary volatility seen in the U.S. Treasuries market over the last week. 

Daily swings in two-year Treasury yields have gotten out of hand. The yield drop of more than 50 basis points that occurred on March 13, following the failure of Silicon Valley Bank, was the greatest since October 1987. Nonetheless, there were days when yields climbed by more than 20 basis points, such as on March 16, putting them comfortably at the top of the range over the previous two decades.

The graph below, which depicts the two-year Treasury yield's daily fluctuations in basis points, mimics a seismograph during an earthquake.

U.S. two-year Treasury yields daily change (bp) - Chart: Koyfin

Markets Lean Toward 25bps Hike: Just a week ago, which seems so long ago considering what has happened since then, markets were leaning toward a 50-basis-point hike in March, as Fed Chairman Jerome Powell sounded rather hawkish in his Congressional testimony. 

Over the weekend, the failure of Silicon Valley Bank and Signature Bank fundamentally altered the game, and rate expectations practically collapsed early this week, with some experts even predicting a Fed cut in March.

Bets on a Fed 25bp rate hike in March have risen after the ECB's 50bp hike on Thursday, and the CME FedWatch Tool now gives this scenario an 80% probability.

Yet investors are already seeing the end of the tunnel drawing nearer.

The terminal rate is now priced at 4.95% for May 2023, and traders expect Fed funds rates to drop to 4.2% by December 2023, implying three 25-basis-point  rate cuts during the second half of 2023.

High Yield Corporate Bonds Screen Attractive Yields: On the high yield spectrum, U.S. corporate bonds continue to provide excellent yields, particularly when compared to their recent history.

According to latest data from the Federal Reserve Bank of St. Louis, the ICE BofA US High Yield Index Effective Yield, which tracks the median yield of U..S. dollar denominated, below investment grade-rated corporate debt publicly issued in the US domestic market, was 8.88%. This value is more than a standard deviation higher than its 10-year average.

The iShares iBoxx $ High Yield Corporate Bond ETF NYSE:HYG is mostly flat so far this year, but it is still 10% lower than it was a year ago.

Read more: Best High Yield Investments to Earn

Chart: Koyfin

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