Duration and VaR: The Fault of the Fed?
Never has it been made clearer to us that monetary policy controls asset prices than when we examine the value-at-risk (‘VaR’) of different portfolios. VaR attempts to estimate the tail of a portfolio - i.e. how much it might lose in an adverse scenario over a given time period, given a specific probability and normal market conditions. Taking a lookback period of one year and an historical VaR approach, Figure 1 shows the daily VaR at 95% of the S&P 500 index versus a portfolio of 10-year US Treasuries and a portfolio 20-year Treasuries.1 The VaR of the S&P 500 and 20-year Treasuries is notably similar. Likewise, investment grade bonds had a fatter tail at 95% VaR than high yield bonds throughout most of 2022, although the effect is now normalising.
Figure 1. 1-Day 95% VaR of S&P 500 Index, 10-Year Treasuries and 20-Year Treasuries Using a 250-Day Lookback
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Source: Bloomberg, Man GLG; as of 1 December 2022.
Why is this the case? 20-year risk-free cash flows should have little in common with equities, traditionally the most volatile asset class and therefore the asset class with the fatter tail. Investment grade (‘IG’) bonds “should” have a smaller VaR than high yield (‘HY’) bonds, given their higher quality.
The answer is duration. The tail risk embedded into the assets with the longer duration such as 20y UST has increased materially in 2022 on the back of the recent bond selloff. Therefore, 20Y UST has a similar VaR than SPX. A similar effect is at play for IG versus HY bonds. IG duration exceeds high yield duration, and is now more than seven years versus five years respectively. The outbreak of inflation, driven by the excessive creation of money in response to the pandemic, similarly drove the VaR of IG credit higher than its HY counterpart (Figure 2) because the tail risk in longer dated rates has materially increased in 2022. This effect could be also illustrated in the 30y Gilt market around the mini budget crisis at which point sold off by 120bps in one day.
Figure 2. 1-Day 95% VaR of IG and HY Bonds Using a 250-Day Lookback VaR
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Source: Bloomberg, Man GLG; as of 1 December 2022.
No Money, No Cry: Is Disinflation Taking Hold?
At last, some good news – growth is collapsing. The growth in question is of monetary supply, which surged as part of the emergency stimulus response to the pandemic. Now it is in retreat (Figure 3). M2 – essentially easily available cash in US bank accounts, savings deposits, and money-market funds – expanded by more than 25% year on year in early 2021. That growth has dropped down towards almost 0%, in October reaching the lowest such rate in the near 30-year dataset.
This matters because the exceptional monetary impulse in 2020-21 significantly contributed to inflation; its dissipation may have the reverse effect. Moreover, there is room for further deceleration as the US banking system is flush with deposits it doesn’t need: USD18 trillion of bank deposits and USD11.5 trillion of bank loans and leases.2 If the banks can’t use these deposits profitably, they will likely shrink them to improve margins. Surveys of senior loan officers already reveal their reluctance to lend.3 At some stage, the Fed may become concerned about the minimum level of excess reserves, which currently stand at around USD3 trillion, but with over USD6 trillion in unutilised deposits that is not an immediate question for today.4
Inflation undershooting is not the consensus view at present: Bloomberg’s forecast for 2023 US CPI rose from 3.9% in October to 4.3% in November, with 85% of the sample expecting inflation to be above 3.5% in 2023.5 Cooler inflation could be as much of a shock next year as hot inflation was this year.
Figure 3. Money Supply Growth is Collapsing
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Source: Bloomberg and Federal Reserve; as of 1 October 2022.
With contributions from: Gilles Gharios (Man GLG – Head of Investment Risk) and Ed Cole (Man GLG – Managing Director, Discretionary Investments)
1. Proxied by liquid ETFs.
2. Source: Federal Reserve; as of 24 November 2022.
3. Source: Bloomberg, “US Banks Are Tightening Lending Standards, Raising the Risk of a Recession”, 21 November 2022.
4. Source: Federal Reserve; as of 24 November 2022.
5. Source: Bloomberg; as of 24 November 2022.
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