Context is Everything




Originally published on Susan Estes Linkedin on 10/19/2016.

The volatility that the bond markets experienced on October 14, 2014 was unlike any other, not due to the extent of the price swings but because of the impact on the market.  After all, as a reader pointed out in response to my previous share, the volatility and price moves in the 1970’s and early 1980’s were likely larger and more frequent.  But as the American psychologist, Noam Shpancer said, “context determines the meaning of things.”

The volatility and price movements that occurred in October 2014, occurred without provocation.  The Federal Funds rate was pegged at 0% and, as reported in a recent Bloomberg article, “Once-in-4,800-Year Shock is Bond Market’s Cold Case Two Years On,” a 2015 report by five government agencies found no smoking gun for the surge and decline in prices during a flash rally that moved yields by almost five standard deviations.

I have not called the reporter, nor compared historical volatility charts but I don’t feel it’s necessary.  There is no mystery. The Fed did not have rates pegged. In fact, interest rate moves in those decades were taking place in a period of unprecedented volatility.  During my junior high school, high school and into my early college days, the New York Federal Reserve Bank raised the Federal Funds rate by a whopping 1650 basis points, from a low of 3.5% in 1971 to a high of 20% in 1979 and 1980—but not in a straight line.

Historical roller-coaster

Let’s take a whistle-stop tour through earlier rate history. In 1973, the Fed stopped just shy of doubling the funds rate as it raised rates from 5.75% to 11%. They continued the increase, raising it another 200 bps in six months to 13% by July 1974. In the six months that followed this 725 bps hike, they abruptly and dramatically changed direction and by January 1975, the Fed funds rate was back down to 7.5%.  A year later the Fed had pushed the Funds rate down to 4.75%, an 825 bps move from peak to trough, greater than the initial surge, and leaving rates 100 bps lower than where they started in 1973.

That’s where the real fun began (although not if you had a mortgage or were taking out student loans).

By the end of 1978, the funds rate was back up to 10%, a “gradual” increase of 525 bps over two years. Six months later, in mid-1979, up another 550 bps to 15.5% before reversing direction once again, plunging 350 bps in the following six months, ending 1979 at 12%.  Enter 1980: yet another reversal pushed the fund’s rate up 200 bps just one month to 14% in January; then up 600 bps to 20% by March and, wait for it, DOWN 750 bps to 12% by September; and then, within three months, back up 800 bps to 20% again by December 1980.

You get the point.  To look at market volatility as simply a historical marker without referencing the rate environment is like looking out of the window and saying ‘it’s hot today’ without knowing whether it is winter or summer.

But important questions have been raised by analysts – and picked up by a handful of smart reporters.  During these historic times or market turbulence, outstanding U.S. Treasury debt had yet to exceed $1 trillion. It’s now worth $13.7 trillion, 98% of which trades with questionable liquidity and depth.

As a trader, I never entered a macro trade without creating a comprehensive risk matrix.  The four corners represented extremes that were low probability events, based on (among other things) a combination of possible (not probable) macroeconomic shocks and extreme historical price moves.  The center represented present day market levels.  I used the matrix to evaluate potential profit or loss of a trade.

Identifying in advance highly improbable events is a healthy exercise.  It removes the surprise.  Regardless of your personal view on the future of the U.S. economy or the long-term sustainability of our current market structure, consider for a moment that you may be wrong.  Consider, rather than dismiss, what could happen if there was another sudden swing, and it was more extreme in either magnitude or duration.  And while the market handled a phantom move with rates pegged at zero, how will it behave if volatility is introduced by intentional interest rate adjustments?

To explore what could happen is not the same as predicting it will happen, nor is it introducing hysteria.  It is prudent risk management.  After all, it is possible the market could face an even sterner test than two years ago.  Let’s hope for the sake of an orderly transition to a new market structure, that when this time comes, we are ready.


Susan Estes is CEO of OpenDoor Trading, LLC, provider of an all-to-all marketplace for Off-the-Run US Treasuries. During her career, she has managed fixed income trading at several major financial institutions including Deutsche Bank, Morgan Stanley and Countrywide Securities. She was also a member of the Treasury Borrowing Advisory Committee under Federal Reserve Chairmen Greenspan and Bernanke.