US: Are implied interest rate vols “too low”? – Goldman Sachs

Interest rate volatility implied in the US bond options market is currently trading near an all-time low, at a 1st percentile relative to its 1999-2017 historical range, notes the analysis team at Goldman Sachs.

Key Quotes

“We address the question of whether current implied rate vols are “too low”, a reflection of complacency on the part of investors. At one level, we suggest that the answer is no: implied vols historically track actual realized rate volatility, and realized rate volatility has also been low. Realized and implied vols have both declined over the past year. The current level of implied vol is in line with its expected level, conditional on the low level of realized vol.”

“Implied rates vols are consistent with lagging realized rates vol. There is also a correlation with future realized vol, but the correlation is less tight: R=91% between implied vol and lagged realized vol, but only 67% between implied and future realized vol. A pickup in implied rates vol will likely have to come from a pickup in realized rates vol, rather than from a pickup in option premium.”

“Realized volatilities tend to be fairly persistent. For example, from October 2004 through August 2007, realized vol remained below its long run historical 50th percentile level. This is consistent with the findings of our portfolio strategy team, who have found in the context of equity options that “low vol regimes are not that unusual and can last for a long time”.  While one might suspect that summer seasonal effects could be suppressing vol, in fact realized rate volatility has declined further from Q3 to Q4 in 60% of the years since 1987.”

“One driver of low realized interest rate volatility has been the relatively modest volatility of real economic variables. Exhibit 3 below shows our US Economics team’s MAP data surprise score, which measures deviations between actual economic data prints and their respective consensus forecasts. The current level of the score is close to zero, meaning that data are coming in close to forecasts on average, and the score has not crossed a two-standard deviation threshold in many months. The surprises that have occurred for the two data points that are arguably most relevant for the bond market, namely unemployment and inflation, have had offsetting impacts, with unemployment rate prints surprising to the positive side and inflation to the negative. A breakout of this pattern could help bring vol higher; we expect unemployment rates to continue to trend down, but look for inflation to increase in the coming months and years.”

“In summary, option-implied interest rate volatility is currently low, as has been the actual realized volatility of interest rates. Any pickup in implied vol will likely come from an increase in realized vol, a pickup which we think could be led by a reversal of the recently soft data on inflation.”