"Yield Speed Limits" And When Will "Risk Parity" Blow Up Again

It appears, as UBS' Stephane Deo notes, that in a rising rate environment, so-called risk-parity portfolios were susceptible to draw-down as yields 'gap' higher. As it turned out the 'equalization of risk across assets within the portfolio' failed dramatically after the Fed's June 19th FOMC statement which sent rates and stocks higher (and moreover rate volatility considerably higher) - the consequence for some risk parity funds was a significant loss. The question is whether this will happen again, or was this event a one-off? We believe this is a relatively mild foretaste of what is to come... as the 'speed limit' for rising bond yields is smashed.

 

The disconnect among cross-asset-class vol as the BoJ broke bonds in December and then the Fed hints at the taper...

 

Will Risk Parity Go Wrong... Again? (UBS' Stephane Deo)

In March we suggested that in a rising rate environment risk parity was susceptible to draw-down as yields gap higher. As it turned out this happened even sooner than we expected after the Federal Reserve’s June 19th FOMC statement. Despite the fact that the statement said nothing new, markets interpreted it as hawkish and Treasuries took a pounding. In the next two weeks ten year Treasuries lost over 4% in total return, creating an overall loss of 7.5% since the beginning of May. The situation was worsened by the fact that equities also fell briefly, but unlike Treasuries also rebounded quickly.



The consequence for some risk parity funds was a significant loss. For example the AQR Risk Parity Fund lost 13% from May 9th to June 24th and fared worse than shares, credit or Treasuries in response to the FOMC sell-off. The question is whether this will happen again, or was this event a one-off? We believe that this is a relatively mild foretaste of what is to come. Consider that this was a response to a hint that the Fed could start to taper its asset purchases which occurred while the Fed was moving its balance sheet far beyond historical limits at a rate of over $1 trillion per year. The responses to the actual onset of tapering and rate hikes are likely to be more severe. Our US economists believe tapering will begin in Q4 this year and end in Q2 next year but that rate hikes will be delayed.

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While the fact that tightening will occur is known, timing is unknown, as is the effect of tightening on fixed income assets. It is useful to think of the susceptibility of fixed income to rising yield in terms of “speed limits”. We define the speed limit of bonds as the rate at which yield can increase such that it wipes out coupon income. Here we update and broaden our analysis of fixed income speed limits to include bunds, JGBs and gilts as well as Treasuries.



Given the extraordinarily low coupon of most developed market sovereign debt speed limits are below 2.5 bp per month for Treasuries, bunds, gilts and JGBs. Investment grade is little better at 5.9 bp/month and even high yield corporate bonds can only absorb 13.1 bp/month. Given that historically the Fed tends to hike in 25 bp increments this suggests repeated mark-to-market loss in the entire fixed income space each time the Fed moves. Not only Treasuries will be affected by the Fed’s policy rate change - to be sure, the high correlation between yield curves suggests the Fed may drag other sovereign yield curves higher with it in a process of policy contagion. This will destroy the sentiment of investors used to seeing Treasuries, bunds, gilts and JGBs as safe stores of wealth...