How the Changing Rates Outlook is Boosting Demand for Convexity Hedging

How do you see the current rates outlook given changing inflation expectations and different speeds among central banks impacting markets?

Ali Khan: There’s everything to play for after the big hikes in 2022. With central banks introducing a new concept of “disinflation” after the February 2023 hikes, the outlook for rates and risk has changed again with interesting markets set to continue for some time. The market will likely gyrate between two competing sentiments in H1 2023, one being that the hiking cycle is close to ending and the other that there is still a lot more work to do to fight second round effects and wage pressures. Data dependency has increased and the Eurozone might decouple a bit from the US as it started hiking later.

Hans-Peter Schoech: “Disinflation” does indeed seem to be the new narrative spread by central banks. This is clearly a big change in rhetoric and it might be an attempt to counter some of the prevalent inflation psychology that has taken hold of the economy. Of course, the risk is that further down the line, either the economy tanks in which case risk assets look too optimistic or inflation proves stickier than hoped for in which case forward rates look too optimistic.

How are clients positioning their books at the start of this year and why?

Ali Khan: Macro investors seemed to start the year with a bearish mindset after the hawkish central bank commentary of December 2022. This positioning was severely tested at the recent central bank meetings. Market moves have been outsized and underscore the importance of risk discipline, correct sizing and the right choice of format (in particular where there is staying power). Real money will find itself in uncharted waters this year both on the asset and liability side.

Hans-Peter Schoech: Last year saw the fastest rate hikes in living memory. This has led to extremely volatile markets full of risks and trading opportunities. Many macro hedge funds and fast money accounts have done very well. For Real Money accounts like Pension Funds and Insurers it’s a different story. Many have seen their portfolios unbalanced and asset-liability management (ALM) challenged. As a result, they are still in the process of assessing their hedging and investment needs.

Some of the relevant themes are losses of reserves from above par assets dropping below par, lapse risk hedging, re-assessment of duration gaps and liquidity risk management. There are also questions of asset allocation as some portfolios have become overweight in Private Credit and Alternative assets, which have held up much better than more liquid Fixed Income assets. Finally, the use of leverage to achieve ALM goals will be carefully reviewed following the UK LDI experience post the mini-budget market rout in September.

Which products are most suited to the current environment considering liquidity and fluctuations in volatility?

Hans-Peter Schoech: We do expect a move out of illiquid and alternative assets into more liquid Fixed Income covering anything in the spectrum from Government bonds to traditional Credit. We also see structured notes with Constant Maturity Swap (CMS) or steepener coupons as a good way to achieve ALM objectives whilst benefitting from the current market environment of a deeply inverted curve.

‘Puttables’ are an interesting investment for being long duration and convexity. In general, we do think owning convexity makes sense in the current environment of extreme macro uncertainty and we are seeing strong demand for convexity in various forms and shapes from real money investors. There is also considerable interest in owning out-of-money options mostly driven by capital considerations.

We are seeing value in liquid alternative investments such as Quantitative Investment Strategies or QIS: Rates momentum and rates value strategies are expected to continue to work well in the current environment and rates vega strategies offer a good way to own convexity and benefit from relative value opportunities across the volatility surface.

How does the current trading landscape compare with similar periods in the past?

Hans-Peter Schoech: In some respects, the environment looks similar to the 1970s with the economy roiled by various supply side shocks. On the other hand, the financial markets are in a very different state after decades of building up debt and leverage and financialization of the whole economy. There are also very large amounts of private capital sitting on the sidelines and waiting to be invested.

Ali Khan: It’s by far the most interesting market since the dawn of the Eurozone. As an example, on the 2^nd of Feb we saw the largest ever 1-day move lower in EUR 10y swaps. It is also worth noting that the investable asset base is much larger today compared with periods of similar volatility in the past so the playbook might be different i.e. does that cap yield sooner than history might suggest?

What grey swan event do you foresee that may upend markets once more this year?

Ali Khan: The biggest unexpected risk is sticky inflation. The central bankers are talking a good game about inflation expectations being well under control (BoE forecasts virtually zero inflation by 2026 if they deliver the market implied interest rate path). But what if second round effects kick-in? We will see higher terminal rates and some assumptions upended.