By Anand Venkataraman, Head of Benchmark and Index Product Management, Parameta Solutions
On August 5, institutional investors around the world woke up to their terminals flashing red. Global markets erupted as fears of a potential recession in the US took hold. The turmoil did not last long, however. A week later, markets had returned to relative normality. The intensity of the market reaction and recovery was a stark reminder of the speed and impact of volatility.
Institutional investors have a variety of sophisticated analytical tools at their disposal, but identifying the cause of volatility and finding an appropriate response is crucial. In August, rising equity indices – such as the VIX or the so-called “fear index” – made headlines and attracted investors’ attention. However, one of the main triggers for the sell-off was participants’ perception of interest rate uncertainty.
Understanding the true sentiment of markets toward interest rate volatility is not only important for those who trade fixed income or derivatives. In times of market stress, all participants need to be able to access data that allows them to see beyond the panic. Accessing the right information and looking at it alongside other data sets can help make more informed decisions, break through the herd mentality, and mitigate some of the fear that contributed to August’s excitement.
Measure your pulse
When global markets are gripped by the growing uncertainty surrounding the transition to a low interest rate environment, there is a significant strategic advantage in cutting through the noise and assessing the true sentiment. Institutional investors must choose the right tools to stay ahead.
Interest Rate Swap Volatility Indexes (IRSV) are an important tool for uncovering the sentiment of interest rate traders who live and breathe interest rates, and provide a unique insight into expected future uncertainty. By representing the implied volatility of swap rates, the indexes can help investors gauge swap rate volatility a month or a year into the future, thereby understanding the likely trajectory of these participants beyond knee-jerk reactions to a market-moving event.
For some, the IRSV indices played a key role in the reaction to the August sell-off. To understand this, you first have to look at how the situation unfolded. The stage was set in late July when the Fed decided to keep rates on hold and hinted at a rate cut in September, which the market interpreted as a sure sign that rates were finally starting to fall. Less than 24 hours later, the BoJ made the seemingly momentous decision to raise rates – suggesting that another hike is possible – which was quickly followed by a spate of disappointing US economic data, led by unemployment figures that came in well above expectations.
This series of surprising events in quick succession set off a chain reaction that temporarily threw markets into chaos – from the rapid unwinding of foreign exchange trades, to fluctuating bond yields due to new interest rate uncertainty, to a rapid sell-off in major equity indices as investors fled to safety. Looking at the IRSV indices, one saw a steep rise in the shorter one-month period compared to the longer one-year period, and increased uncertainty in the shorter swap maturities (usually referred to as the “top left” of the volatility cube) compared to the longer maturities.
Similar behavior of the IRSV indices has been shown in previous cases. Take the SVB collapse and the subsequent stress on the European banking sector as an example – on March 10, at the time of the SVB collapse, the indices recorded a dramatic increase in one-month implied volatility compared to one-year implied volatility, changing the volatility term structure. The immediacy of the impact on the indices and the granularity available for different time horizons and interest maturities allowed participants to look beyond the headlines, assess the real impact of events and act decisively in a difficult environment.
Prevention is better than cure
Data science and analytics have made great strides in a relatively short period of time, allowing investors and risk managers to assess market sentiment beyond short-term panic, but also to avoid complacency. To stay ahead, investors must use diverse and sophisticated tools to help them assess market uncertainty.
While the use of IRSVs is essential, institutional investors can include them as part of a broader dataset to guide their decisions. For tactical investment decisions, it is essential to collectively identify the relevant sources of uncertainty affecting market sentiment – in the case of the August sell-off, interest rates – and use appropriate tools to make more informed decisions.
Implied volatility for one month
Implied volatility for one year
