Interest Rate Volatility Heading Lower?

U.S. interest rate volatility has been at elevated levels for more than two years as the Federal Reserve embarked on a steep interest rate hiking cycle to combat the highest level of inflation seen in the U.S. since the early 1980s. Now as the inflation cycle has turned and inflation has declined the Federal Reserve has signaled that it will begin to cut its key policy rate in the coming months. Connected to this shift in central bank policy interest rate volatility has started to decrease and could potentially break below the elevated range of the past two-years. The MOVE Index (Merrill Lynch Option Volatility Estimate), a commonly quoted gauge of US interest rate volatility, reached?a 2-year low of 86 last week and yet was still at the high end of the 10 year range. This follows a busy week of central bank announcements which mostly leaned dovish. The Bank of England and the Federal Reserve kept their policy rates unchanged while the Bank of Japan hiked for the first time since 2007 but all gave dovish commentary. The Swiss National Bank delivered un unexpected rate cut of 25bps. ?This dovish shift has reduced uncertainty over central bank policy and has, at least for now, resulted in a decline in the MOVE Index.

Historically low or moderate levels of interest rate volatility has provided a tailwind for spreads of mortgage-backed securities over Treasury yields. With investors expecting the Federal Reserve to begin cutting interest rates this year and a healthy economy, interest rate volatility could very well continue to decline or at least stabilize at less than decade high levels. The mortgage-backed securities market would be a prime beneficiary of normalizing interest rate volatility.

However, the path to lower rate volatility is likely to be non-linear as rate volatility is very sensitive to macroeconomic data, especially inflation. This week unexpectedly strong ISM PMI data triggered large moves across Treasury curve and higher rate volatility. In four days, the MOVE index reversed most of the decline that took place during the second half of the March. With some mixed signals on inflation in recent months and growing economic optimism, the path for interest rate volatility could be volatile itself.