Credit-market volatility has fallen in recent months, particularly in the investment-grade universe. Yet as the US election, a potential hard Brexit and a resurgence in coronavirus cases loom on the horizon, this recovery could come to a halt as the market catches up with forward-looking, options-market-implied volatility.
Expectations about the pace of the economic recovery and the likelihood of central-bank support have risen in recent months. This was evidenced by the muted reaction to news that the Federal Reserve would move to an average-inflation target, communications that interest rates would stay lower for longer and an upgrade in the fundamental outlook. Economic-surprise indices have declined, reflecting how expectations have swung from extremely negative to very positive.
It takes incrementally more good news for markets to move higher, meaning that it has become harder for data to beat expectations. Looking back at the 19 days when the iTraxx Crossover moved more than 20bps wider in a day over the past year, two of these days took place in the last week (see figure 1).
Figure 1. Volatility is on the rise
Source: Bloomberg, as at September 2020.
It seems certain there will be a pick-up in volatility over the rest of the year. Nonetheless, central banks still have some tools at their disposal and will likely react to a period of heightened volatility with outright yield targeting or by modifying the corporate-bond-buying programme.