US Rates Strategy: The Risk of Extrapolating Stability

Research evidence excerpt

US Rates Strategy: The Risk of Extrapolating Stability

IdeaM

Interest Rate Derivative Strategy

United States | The risk of extrapolating stability

Shaun Zhou

MORGAN STANLEY & CO. LLC +1 212 761-3348

Shaun.Zhou@morganstanley.com

Matthew Hornbach, CMT

Matthew.Hornbach@morganstanley.com +1 212 761-1863

Martin Tobias, CFA, CMT

Martin.Tobias@morganstanley.com +1 212 761-6076

Aryaman Singh

Aryaman@morganstanley.com +1 212 761-1993

Eli Carter

Eli.Carter@morganstanley.com +1 212 761-4703

Markets extrapolate

At the end of February, investors were extrapolating prevailing market trends: rates rallied

on expectations that the incoming Fed chair could be more dovish, while equities came

under pressure amid concerns around AI-related growth expectations. Positioning

reflected this regime. Investors accumulated low-strike receivers as downside rate hedges,

while few were positioned for a repricing toward Fed hikes.

As a result, when the closure of the Strait of Hormuz shifted the inflation outlook and

forced the market to reprice from Fed cuts toward hikes, rates moved sharply and

volatility rose significantly.

Since the initial shock from the Iran conflict during March and April, markets have

stabilized. Over the past month, the rates volatility market has reverted to a more

conventional regime: short-expiry implied volatility is again anchored by realized volatility,

with the surface embedding a modest risk premium when realized vols are low.

Relative to realized volatility in 30y rates, 3m30y implied volatility is now near the lower

end of its historical range, suggesting that the market expects market to remain calm over

the next few months ( Exhibit 1 ). In addition, conditional on the current level of 3m30y