By Aaron Saldanha and Lisa Pauline Mattackal
(Reuters) - After a decade of central bank bond buying, fund managers have begun to wonder if there is again money to be made in betting or hedging against volatility in the bond market caused by an economic recovery next year.
The ICE (NYSE:ICE) BofA MOVE Index, which tracks expectations of volatility in Treasuries, is again languishing near all-time lows after a spike in March was quelled by U.S. Federal Reserve intervention.
But a handful of fund managers, and some major banks, warn of the risk of a spike in inflation next year that could spur losses for bond funds and more volatility before the Fed steps back in, or eventually even change the central bank's stance.
Nancy Davis, who manages the Quadratic Interest Rate Volatility and Inflation Hedge ETF, said she has seen a jump in interest in recent weeks from investors worried about the impact of rebound in some of the consumer and asset prices quashed by this year's crisis.
She argues that while stock markets have accounted for COVID-19 vaccines spurring a swift recovery in 2021, debt market indicators of inflation have not budged, leaving bondholders exposed if headline price growth moves.
"Equities already seem to be pricing this in, but the rates market hasn't," Davis told the Reuters Global Markets Forum (GMF) last week.
"In the U.S., we are likely to get fiscal stimulus from the new administration combined with the loose monetary policy that could push inflation higher, it is probably an underpriced risk at this point," she added.
While any sustained spike in yields would likely be met by action from the Fed to talk them down, in the back of some investors' minds is the risk that officials could at some point be satisfied that economic growth justifies higher yields.
In the year through Nov. 18, Lipper data shows IVOL's assets under management rose more than nine times to $752.2 million.
OTHER SIGNS
As central bank bond purchases suppress rate volatility, investors have turned to markets like stocks and foreign exchange for signals on the macroeconomic outlook.
Wall Street's consensus is that inflation will remain fairly dormant. U.S. 5-year Treasury Inflation-Protected Securities(TIPS), or inflation-linked bonds, show the anticipated "break-even" rate of inflation in five years at around 1.67%, below the Fed's average target of 2%.
Yields on both 5-year and 10-year TIPS have been firmly in negative territory since March and are currently at -1.31% and -0.92% respectively.
Five-year breakeven rates, however, have picked up from under 1% in June, and some houses have listed unexpected inflation moves as a risk.
Analysts at French fund manager Amundi said this month that overshooting inflation is unlikely, but recommended investors consider inflation-linked bonds to position for a remote yet possible snapback in inflation under an 'upside scenario'.
Morgan Stanley (NYSE:MS) strategists recommend buying 5-year breakevens, forecasting break-even inflation rates across the U.S. curve to rise above 2% by the end of 2021.
Countering that is the wide-ranging conviction that, even if inflation does tip higher, Fed buying will keep fixed rate bond prices high and quell yields as it seeks a more durable expansion in inflation expectations and growth.
Another fund manager focusing on the need to vary bond strategies, David Wagner of Aptus Capital Advisors, told the GMF the Fed would keep pressure on yields. But he also pointed to a bumpier road ahead.
"The underlying theme here is that we believe there could be increased volatility in the future," he said.