How quantitative easing impacts government bond markets and the duration model

WHITE PAPER January 2014 For professional investors How quantitative easing impacts government bond markets and the duration model Johan Duyvesteyn Martin Martens Olaf Penninga How quantitative easing impacts government bond markets and the duration model 1

The duration model in distorted bond markets In this note we investigate how quantitative easing affected government bond markets and the duration model. We find that the Fed has distorted bond markets, especially by reducing volatility. This has impacted the performance of the duration model. The duration model determines the active positions in the funds Robeco Lux-o-rente and Robeco Flex-o-rente. We continuously monitor the performance of the model. In 2007 1 we published sensitivity analyses showing that the model performs well under a variety of market circumstances: in bull and bear markets, with steep and flat yield curves and across different stages of the business cycle. We now investigate how the Fed s Quantitative Easing programs have affected market dynamics and the performance of the model. What did the Fed do in its quantitative easing (QE) programs? The Fed started to buy USD 600bn of Mortgage-Backed Securities (MBS) and Agency Debt in November 2008, but already in March 2009 it raised the targeted amount to USD 1,750bn and included Treasuries. These QE1 purchases were completed in March 2010. In August 2010 the Fed resumed buying Treasuries, increasing the target by another USD 600bn ( QE2 ) in November 2010. In 2011 and 2012, the Fed sold short-dated Treasuries replacing them by USD 667bn of bonds with long maturities. This operation Twist aimed to push long-dated bond yields down. In September 2012, the Fed started an open-ended purchase program with monthly purchases of USD 85bn inmbs and Treasuries. This is the program ( QE3 ) the Fed has just started to taper (i.e. to reduce). Figure 1 below shows how the Fed s security holdings have risen by more than USD 2.5 trillion since late 2008. How quantitative easing affected bond markets and the performance of the duration model We see three potential ways in which the Fed s bond buying could have influenced the bond market: 1. The buying of government bonds by the Fed may have influenced the direction of the bond market. 2. Movements of the yield curve may have changed as the Fed has effectively anchored the short end of the yield curve. 3. The volatility of the bond market may have changed as the Fed has aimed to keep bond yields down. To start with the first point, the Fed obviously supported bond markets with its large-scale purchases. Global government bonds returned on average 2% in excess of cash per year over the past 5 years. However, global government bonds also outperformed cash by 2% on average per year in the ten years before QE was introduced. The duration model generally performed well in this decade. This clearly illustrates that a bullish market environment need not impact the model s performance. 1 The duration model's performance. April 2007 How quantitative easing impacts government bond markets and the duration model 2

Figure 1. Fed security holdings 31-12-2013 4,000 QE1 QE2 Op Twist QE3 3,500 3,000 2,500 2,000 1,500 1,000 500 0 Fed Securities holdings, $bn Source: Federal Reserve Bank of New York Regarding the movements of the yield curve, we do indeed see a different pattern in recent years. The Fed keeps the short end of the yield curve anchored near zero, so only the long end of the curve can move meaningfully. As a result we mainly see bull flatteners (yields decline and the curve flattens) and bear steepeners (yields increase and the curve steepens) since the end of 2008. Until 2008 we had more bull steepeners (yields decline and the curve steepens) and bear flatteners (yields increase and the curve steepens) and less bull flatteners and bear steepeners. However, there is no consistent relationship between these curve movements and the model performance. The different curve dynamics have thus not measurably impacted the model s performance. Negative impact of reduced volatility on model performance The Fed has deliberately anchored short-end yields and pushed down long-dated bond yields. As the Fed also promised to keep this easy policy in place for a considerable period of time, we would expect a dampening effect on bond volatility. Figure 2 shows that bond volatility (as measured by the MOVE 2 index) has indeed declined strongly since the announcement of QE. The MOVE index was above 200, twice its longterm average, when the Fed announced QE1. It declined to a low of 49 in April 2013, just before the Fed started to signal tapering. Bond volatility thus declined from crisis levels to 50% below the normal level during the QE period. 2 Merrill Lynch Option Volatility Estimate, an index of US Treasury implied volatility. How quantitative easing impacts government bond markets and the duration model 3

Figure 2. Volatility of US government bonds (as measured by MOVE) 300 MOVE index QE 250 200 150 100 50 0 Apr-88 Apr-89 Apr-90 Apr-91 Apr-92 Apr-93 Apr-94 Apr-95 Apr-96 Apr-97 Apr-98 Apr-99 Apr-00 Apr-01 Apr-02 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 Apr-12 Apr-13 Source:BoFa Merrill Lynch To investigate whether the decline in volatility has impacted the performance of the model we perform two analyses. We compare the performance of the model in times of high and low volatility, and in times of rising and declining volatility. From Figure 3 we observe that the model performs well regardless of the level of the MOVE. This fits with our finding in previous research that the model performs well under a variety of market circumstances. Figure 3. Duration model performance as a function of the level of MOVE Low volatility High volatility Source: Robeco and BofAMerrill Lynch How quantitative easing impacts government bond markets and the duration model 4

Figure 4, however, provides us with a new insight. It shows that the model clearly has a stronger performance when the MOVE rises and a weaker performance when the MOVE falls. This relationship holds both before and after 2008. Figure 4. Duration model performance as a function of changes in MOVE 3 Declining volatility Source: Robeco and BofAMerrill Lynch Rising volatility The stronger performance in times of rising volatility fits with our earlier anecdotal evidence of strong model performance during equity market crises such as 1998, 2001 and 2008. This is a useful property: the model has tended to provide strong performance just when many investors needed it most. The flipside, however, is that model performance is generally weaker in times of declining volatility. The strong reduction in bond market volatility that the Fed engineered over recent years has thus provided a more difficult environment for our duration model. Volatility started to rise again in the second quarter of 2013, when the Fed announced it would probably start tapering later that year. Volatility thus started to normalize when the Fed indicated that it would gradually loosen its grip on bond markets. That quarter was indeed a strong quarter for the duration model, illustrating the relationship between changes in volatility and model performance. Tapering will improve market conditions for the duration model Note that the relationship between changes in volatility and model performance only explains when the model is stronger or weaker than average. It cannot be used directly to predict bond markets so it is not yet a candidate to become a new variable in the model. However, understanding when and why the model performs often generates ideas for new research into potential further enhancements. For now, as the MOVE index is still at relatively low levels and the Fed has just started to taper its asset purchases, a further normalization of bond market volatility might be expected. As the model generally performs better in times of rising volatility than in times of falling volatility, such a rise in volatility should constitute a more favorable backdrop for the model than the declining volatility engineered by the Fed over recent years. 3 We assign each month since April 1988 (the start of the MOVE index) to one of four buckets based on the level of the MOVE index (left graph) or based on the 1-month change of the MOVE (right graph). The graphs show the performance of the model for each bucket. How quantitative easing impacts government bond markets and the duration model 5

Conclusion: expected rise in volatility in favor of model The Fed s unprecedented actions over the past five years have impacted bond markets. We have analyzed whether the Fed produced more bullish markets, whether it changed the dynamics of the yield curve and whether it impacted the volatility of the bond markets. For these three cases we have also investigated whether the Fed s market distortions -if any - impacted the model performance. First, despite all the Fed s supportive measures, the strong bond market performance is not a unique feature of the QE period. Bond markets were equally strong in the decade before QE. Regarding the second point, the dynamics of the yield curve have changed because of the Fed s actions, but this has not visibly affected model performance. Only for the third point do we see a clear impact on model performance: the Fed has restrained bond yields and hence reduced bond market volatility strongly. Model performance in times of rising volatility is clearly stronger than in times of declining volatility. The strong reduction in bond market volatility that the Fed engineered over recent years has thus provided a more difficult environment for our duration model. We will investigate further whether we can use this insight to improve the model. For now it helps to explain model performance. Volatility is still low, although it has started to normalize as the Fed is gradually reducing its extraordinary bond market operations. If volatility rises further, this should constitute a more favorable backdrop for the model. Johan Duyvesteyn Martin Martens Olaf Penninga Quantitative Research Quantitative Research Fund manager Robeco Luxo-rente and Robeco Flex-orente How quantitative easing impacts government bond markets and the duration model 6

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