Why rising yields and market volatility are good signs

After an usual period of tranquility, this year marks the return of volatility to markets. But that doesn’t mean the economic outlook has changed or that investors should necessarily worry.

Read: Why volatility shouldn’t scare investors—and what should

Referring to furor over Treasurys reaching 3% last week, Sal Guatieri, BMO senior economist, has these words of wisdom for investors: “Get a grip.”

He makes his case in a weekly financial digest, noting that Treasury yields are only one percentage point above core CPI inflation, compared to an average real yield of 2.4% in the past six decades and 1.7% in the past two.

“This means the yield likely needs to rise three-quarters of a percentage point to return to neutral levels, which we don’t see happening until 2020, and only if the Fed lifts rates seven more times,” he says.

Further, higher bond yields mean “investors see a greater chance of inflation rising than the economy shrinking,” he says, and higher yields also attract capital to the U.S. economy.

Still, investors’ reticence concerning rising yields is understandable, considering central banks have held down policy rates for so long, he says.

“Apart from a few odd months, the Bank of Canada has kept real policy rates negative since November 2008,” says Guatieri. “This might have been necessary during the early days of the recovery, but not nine years into an expansion, especially with governments in both [Canada and the U.S.] priming the fiscal pump.”

Investors get rational about risks

Market alignment to the Fed’s view of higher rates and some deterioration in international sentiment helped trigger recent volatility for equity markets. In a report, TD economists describe that sentiment as “merely returning volatility to normal levels.”

Read: Don’t bump up equity exposure—for now

Comparing volatility data based on a one-year rolling change of equity valuations, the report reveals that there were only eight instances of a 1% daily move in the S&P 500 in 2017, the lowest print since 1965, making last year a true volatility outlier. Now, daily movements are approaching the long-term average.

The report also explains that increased volatility doesn’t change the economists’ forecasts. “Just as we didn’t overreact and dramatically lift our growth forecasts when equities soared last year, likewise we don’t perceive the current amount of volatility as a force that undermines the near-term outlook.” For example, GDP forecasts for developed countries (ex-U.S.) are moving toward more sustainable figures, and are already built into economists’ outlooks.

Volatility motivates investors to likewise respond to market events instead of shrugging them off.

As a result, “A greater alignment to economic and financial risks can actually help mitigate future risks of asset mispricing,” says the report. Treasury yields reaching 3% is an example of that, as markets start to embed inflation and interest rate risk into the Treasury curve.

Summarizing their position, the economists say, “Volatility is back. Though it sounds like a negative, it’s actually not. Markets are responding to risks in a more rational way.”

Present risks include the potential that U.S. fiscal stimulus, trade frictions and tighter labour markets lead to stronger inflationary forces.

Greater Treasury supply coming into the market via the need to fund larger deficits and the Federal Reserve’s extraction from prior asset purchases also place a risk that long-yields will rise more than markets currently expect, says the report.

But unless risks intensify, Guatieri’s bottom line is that “a moderate further rise in bond yields should merely slow the equity train rather than derail it.”

Read the full reports from BMO and TD.

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Volatility has fund buyers changing investment strategies: survey