Bond markets - is this just a return to normal

 

There is consternation in the bond markets that may be unwarranted. Rates are higher, and the sell-off has been strong, but we are returning to the normality seen before the GFC. Was the post-GFC period normal, or is the current environment, with a positive real rate, an inflation premium, and a term premium, the norm? 

I would argue that the current environment is a return to normality, and the low interest rates during the QE period were abnormal. The Fed and the Us Treasury cannot be in a continual mode of amping up the economy. There has to be a focus on inflation and controlling credit excesses. Of course, there is a threat of recession, and people will be in need, but the labor market is close to full employment, and inflation is well above target. 

Should we expect lower bond yields, or is the market just reflecting reality? 

Exchanges mergers and EU Capital Market Union (CMU)

An important news article states that Euronext is open to a merger with Deutsche Börse, which would be an important step in the one-European-exchange move to unify rules and regulations for stock trading; that is the hope. One of the most urgent and important discussions about competition in EU integration is reducing bottlenecks in capital markets. The EU has been a laggard in venture capital and private equity funding. New companies look to the US for capital. The disperse set f stock marklets redcues liqudity and makes any listing more expesneive in Europe. A consolidated exchange environment should allow for better listings, more liquidity, and lower operating costs across European markets. 

It is early to say whether there will be any merger announcement, yet a discussion is a good first step. 

Inflation expectations are still high

 

Inflation won't be tamed in the near term. First, CPI is staying above 3%, not 2%. Second, PPI isn't supporting lower inflation. The PPI is usually volatile, but commodity prices are rising with greater volatility.

While longer-term inflation expectations suggest inflation could get closer to the 2% target, one-year expectations aren't falling toward 2% and are centering around current levels above 3%.

The danger in in the covariance matrix

 

While most investors focus on volatility, the covariance matrix can significantly affect performance and is hard to measure. A large covariance matrix with N assets will have N(N+1)/2 free parameters and T degrees of freedom based on the number of observations. A large portfolio will be hard to calculate and difficult to use out of sample. 

Work has also been done on shrinkage estimates, which suggests that the raw sample covariance should contribute only about 20% to the new covariance matrix. Linear shrinkage does better than nonlinear out-of-sample estimates. Overall, shrinking toward zero correlation will help long-short portfolios because they rely less on extreme values. 

The problem is that, in optimization, weights depend on risk aversion, the inverse of the covariance matrix (the precision matrix), and expected returns. Estimation errors are amplified during inversion. A 10% mistake in the covariance matrix will cause the precision matrix to take much larger values, which can be catastrophic. 

Additionally, illiquidity can distort covariance in hidden ways. Illiquidity creates positive autocorrelation in the return series, so measured volatility is lower than true volatility and measured covariance is lower than true covariance. 

These issues are one reason funds should focus on covariance across the environment and try to adjust for relative volatility and risk contribution. It is not just the overall volatility that is an issue but the link across markets which defines diversification and the risk hidden within portfolios.