IVOL - IVOL: A Buy If You Think Recession Is Imminent
2023-04-07 11:12:40 ET
Summary
- The IVOL ETF holds a position in the SCHP ETF plus a portfolio of OTC yield curve steepener options.
- The IVOL ETF benefits when TIPS bonds increase in value or if the yield curve steepens.
- As the drumbeats to a U.S. recession increase, traders are placing bets that the Fed will have to start cutting interest rates soon.
- Historically, yield curves steepen heading into or during a recession. The IVOL ETF is a buy if you think a recession is imminent.
A few weeks ago, I wrote an ill-timed cautious review of the Quadratic Interest Rate Volatility and Inflation Hedge ETF (IVOL). My main concern at the time (late February) was that the yield curve was heavily inverted and getting more inverted by the day as the Fed was intent on raising interest rates 'higher for longer' to fight stubborn inflation. Unfortunately, IVOL's portfolio is composed of long-term TIPS bonds (via its holdings of the Schwab U.S. TIPS ETF) plus a portfolio of yield curve steepener options, which loses value as the yield curve inverts.
Unfortunately for the author (and fortunately for IVOL unitholders), market gods had other plans as a regional banking crisis in mid-March sparked fears of credit contagion and recession. Since troubles at SVB Financial Group ("SIVB") began on March 9th , the 10-2 yield curve (10 Yr treasury yield minus 2 Yr treasury yield) has steepened by 58 bps, from a low of -107 bps to 49 bps (Figure 1).
Figure 1 - 10-2 yield curve has steepened dramatically (St. Louis Fed)
A steepening yield curve has provided a shot in the arm for the IVOL ETF, helping the fund rally almost 12% (Figure 2).
Figure 2 - Steepening yield curve has boosted IVOL ETF (Seeking Alpha)
Looking forward, is there more potential gains ahead for the IVOL ETF, or should beleaguered investors take the windfall rally and exit?
Brief Fund Overview
First, a brief overview of the IVOL ETF, for those unfamiliar. The Quadratic Interest Rate Volatility and Inflation Hedge ETF ("IVOL") was launched by former Goldman Sachs head trader, Nancy Davis , and is marketed as a product that protects against inflation and fixed income volatility. The IVOL ETF owns Treasury Inflation Protected Securities ("TIPS") and a portfolio of fixed income options (Figure 3).
As of April 5, 2023, the ETF had 77.4% allocated to the SCHP ETF, 5.2% allocated to cash, and the rest allocated to long OTC options on yield curve 'steepeners'.
Banking Crisis Leading To Favourable Environment For IVOL?
Although equity markets remained sanguine, with the S&P 500 Index notching a 3.5% return in March, other asset classes like bonds have reacted more strongly to the U.S. regional banking crisis that continues to develop.
While the government's actions to bail out SIVB depositors have averted a disorderly bank run, deposits continue to exit regional banks due to unattractive deposit rates and remain an issue for the U.S. banking sector. This is expected to "result in tighter credit conditions for households and businesses" according to Fed Chair Powell .
Tighter credit conditions could be equivalent to one or more interest rate hikes, according to the Fed, and there is a fear among traders and economists that a U.S. recession is now inevitable (Figure 4).
Figure 4 - 99% probability of a U.S. recession (Conference Board)
A slew of weak economic data released in the past week have further confirmed that the U.S. economy was decelerating in March, even before the regional banking crisis (Figure 5).
Figure 5 - Economic data have come in weak in the past week (fxstreet.com)
Looking forward, it appears the Fed's interest rate hiking cycle may be over. In fact, fixed income traders are now assigning a 49% probability that the March rate hike was the last interest rate increase of this cycle, and that the Fed will begin cutting interest rates as soon as September (Figure 6).
Figure 6 - Fixed income traders bet the Fed will cut interest rates in Q3/2023 (CME)
For the IVOL ETF, this dramatic shift in interest rate expectations have rapidly steepened the yield curve and boosted the fund's fortunes, as mentioned at the start of this article.
Recessions Coincide With Curve Steepening
Looking at historical data, we can see that if the U.S. economy does fall into a recession, there is a very high probability the 10-2 yield curve will steepen dramatically, as the Fed usually cuts short term interest rates to stimulate growth during recessions (Figure 7).
Figure 7 - Yield curve steepens during or before recessions (St. Louis Fed)
In all 6 of the most recent recessionary episodes, the yield curve steepened either during or immediate before the recession.
Risks To IVOL
The clear downside risk to IVOL is that if the U.S. economy is able to muddle along without falling into a recession and the Fed does not have to cut interest rates to stimulate growth, then the yield curve may not steepen further and the curve steepener options the IVOL ETF holds will decay in value.
Furthermore, if inflation declines as the economy slows (due to increased slack), then the TIPS bonds the IVOL ETF holds may lose value, negatively impacting returns.
Conclusion
In summary, if you believe the U.S. economy is heading into a recession, then the IVOL ETF is a buy, as the yield curve typically steepens during or heading into a recession. So far, the yield curve has steepened by 58 bps in the past month, but it is still inverted, so there is still scope for further steepening. I believe a recession is a high probability, so I rate IVOL a buy.
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IVOL: A Buy If You Think Recession Is Imminent