In probability theory, the expected value of a random variable will equate to the long-run average of the variable being measured. For example, the expected value of flipping a coin will result in an equal distribution of “heads” and “tails” under a large enough distribution. In smaller samples you could see the count skewed to one side, but over a larger sample the values will revert toward the mean. Based on this framework it is possible to derive expectations about the mean or average value.
With normal distributions, most values are centered on the mean. Distributions that have a large number of values that fall into the extremes and deviate significantly from the mean are said to have “large” or “fat” tails. The markets this week reminded investors that expectations tied to averages and history can be wrong. Price movements in interest rates, commodities, and currencies continued to register extremes and push trading into levels well beyond historic norms. Crude fell by 9.5% this week as the price per barrel of oil fell to $48.34. Historically, OPEC has culled production when prices have dropped significantly. OPEC’s, and more specifically Saudi Arabia’s, lack of action, has left investors confused and questioning exactly how low oil can fall.
Like crude, global sovereign rates have continued to push into new lows as the deteriorating economic picture in Europe weighed heavily on trading. Europe’s issues began with speculation tied to Greece’s possible exit from the euro only to culminate with the market’s deflation fears being realized. European consumer prices for December dropped by -0.2%, below the -0.1% expectation, a sharp drop-off from November’s 0.3% increase.
Against the weak backdrop, European rates saw yields in the larger economies fall by 4 to 6 basis points, while levels in the peripheral economies rose as their risk was re-priced. German rates continued their descent as 10-year Bunds hit new lows at 0.47%. Perhaps more interesting is the fact that German rates out to 5 years are now negative. Investors are literally willing to accept the loss of principal in return for safety.
U.S. rates saw a dramatic move as yields fell by as much as 16 basis points. The middle of the U.S. curve was the best performer as investors looked to balance their need for yield against the risks of duration. The 10-year hit an intraweek low of 1.92% before pushing back to 1.96% on Friday. Most investors had entered the week expecting rates to push higher and were clearly caught on the wrong side of the move.
With the strength in the middle-dated maturities, the yield curve saw a flattening on the front end. The spread between 2-year and 10-year Treasuries finished the week 5 basis points narrower at 140. Out the curve the spreads finished the week unchanged as the spread between 10-year and 30-year Treasuries finished the week at 58 basis points. The U.S. yield curve is likely to continue flattening as investors continue to be pushed out the curve as they seek out higher yields.
Comparatively, there continues to be a strong relative value story for U.S. debt as the spread between Bunds and Treasuries narrowed by 14 basis points, to 147. With German rates now negative out to 5 years, U.S. rates are one of the only places to find yield. Even if the U.S. economic picture continues to improve, the dearth of available yield outside of the U.S. will likely mitigate the extent of any domestic rate increase.
As we close the week, we are seeing investors being forced to reassess and recalibrate their expectations. This process is volatile and we are clearly seeing this manifest itself in the price action. Historically unprecedented levels of stimulus have completely skewed both risk and return. Looking forward, we are likely get more of the same as the European Central Bank embarks on its rendition of quantitative easing. Investors are quickly learning that the market is not normal and expectations around normalcy need to be replaced with an understanding of extremes. Trying to play to expectations around markets may seem like flipping a coin now in more ways than one
Sean Fallon, CFA, is Senior Vice President of Stephens Inc. He joined Stephens in July 2012 to head the Municipal Taxable efforts and to trade CMBS, Agency CMBS, and ABS. He has 19 years of experience managing and trading fixed income assets.