Interest Rate Volatility Plunge Threatens QIS Strategies

Wall Street is undergoing a noticeable shift as a sharp drop in US interest rate volatility is wreaking havoc on one of the most popular hedging strategies in the financial market. Particularly affected are the protective Quantitative Investment Strategies (QIS) developed by major banks and sold to financial institutions.

What are QIS Strategies?

QIS strategies are essentially "systematic trading portfolios" sold in the form of swap contracts to hedge funds, pension funds, and other institutions. Their primary function is to provide "insurance" against significant potential economic risks. Most QIS strategies are built around "10-year/20-year swaptions," which are 10-year options that allow investors to enter into 20-year interest rate swap contracts. These options serve as protection tools against interest rate volatility and reflect market expectations for future volatility.

Recent Losses in QIS Strategies

According to data compiled by Bloomberg, the volatility of various assets is generally narrowing, and the aforementioned swaptions are experiencing their largest monthly implied volatility drop since November 2023. LumRisk data indicates that this means many QIS strategies designed to profit from rising contract volatility have recorded an average loss of 2.6% this month.

Analyzing the Reasons for the Decline

Experts attribute this decline in interest rate volatility to several factors, including: * **Closing Hedging Positions:** Investors closing hedging positions on mortgage-backed securities (MBS). * **Interest Rate Cut Expectations:** Market expectations that the Federal Reserve will continue to cut interest rates. * **Decreased Concerns about Fiscal Deficit:** Lower level of concern about the US fiscal deficit. * **Political Flexibility:** Market expectations that politicians will intervene to avoid economic crises.

Future Market Concerns

This significant volatility raises concerns in the market about the potential for further deleveraging in the QIS space, especially since the specific performance of different QIS products varies due to differences in product design. Some believe that the decline in long-term interest rate volatility may not last, especially given the lack of widespread liquidation of related QIS products. They also emphasize that doing these deals still makes sense if it helps investors hedge against risks such as "US debt default" or "political turmoil in a European country."