After a long period of higher interest rates, the Fed surprised with a 50 basis points cut. It is now time to review interest rate volatility and its implications.
After an extended period of 0% interest rates and quantitative easing due to the GFC, the Fed started hiking rates in 2016, but the pandemic forced a violent return to 0% in early 2020. High inflation forced the Fed to start hiking rates again in 2022. The Fed Funds Rate peaked in July 2023 and stayed at those levels for 14 months and until the 50 basis point cut this week.
With rates near the zero lower bound, market participants almost forgot about the impact of rate volatility, but now is the time to refresh our memories. There is an overwhelming belief that the path to a neutral rate of around 2% will be smooth. However, this has not been the case historically. It is still possible for rates to go down, but with short periods of policy adjustments to dampen inflationary pressures. These cycles cause interest rate volatility, resulting in higher market uncertainty. In fact, it is possible that, due to forecasts of higher uncertainty, the market may initially experience a correction after a change in policy from restrictive to accommodating.
How do we measure interest rate volatility? There are several possible choices (see reference at the end). In this article, we will use the 12-month standard deviation of the rate (SDR) and the 12-month standard deviation of the log of the rate (SDLR). The results are shown below.
The two measures of volatility yield significantly different results as expected. The SDR plot shows that outliers caused high volatility during the 1970s and 1980s. Following a period of 0% interest rates and quantitative easing, volatility decreased and fell to zero, only to increase again in 2022.
The SDR provides a better measure for fixed-income market uncertainty. This is true because the change in the value of bonds depends on the level of interest rate changes. For example, 2022 was one of the worst years for the bond market.
On the other hand, SDLR could offer a measure of interest rate policy uncertainty because the log better reflects percentage changes as compared to the absolute changes in SDR. The above chart shows that despite rates peaking in the 1980s, the log values remained relatively low compared to the recent peaks caused by the rapid cutting cycle in 2019 and the subsequent panic hikes in 2022. The recent twin peaks reflect high policy uncertainty.
It is highly likely that policy uncertainty will increase while the fixed income market impact will decrease. This could translate to conditions that favor bonds over stocks, although the latter could still gain. Regardless of the outcome, it seems that despite a prolonged period of rates at the zero lower bound, the uncertainty surrounding rate policy has increased since the GFC. This does not mean that the Fed will fail, but that the difficulty in executing policy has significantly increased, and the probability of policy mistakes is higher.
Reference: “Interest rate volatility in historical perspective,” Harvey Rosenblum and Steven Strongin, Economic Perspectives, Vol. 7, No. January/February, 1983.
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