Morgan Stanley: US rate volatility may rise if the Fed reduces forward guidance

Overview

This report discusses the impact of possible changes in Fed communication policy under Warsh's leadership on volatility in the US rates market. Morgan Stanley believes that if the Fed reduces forward guidance, the market will rely more on economic data to judge the policy path, and surprises in data such as NFP and CPI may have a stronger impact on front-end rates. Using the Greenspan era as a historical reference for limited forward guidance, the report quantifies changes in market sensitivity to economic data and infers upside risks to short-dated and medium-dated rate volatility.

Core views

The core view is that less forward guidance means greater data dependence, and greater data dependence usually corresponds to a stronger rates market reaction. The report finds that from the Greenspan era to the pre-pandemic Powell era, the market's sensitivity to employment data surprises declined continuously, then rebounded after the pandemic due to high inflation and macro shocks; if Warsh continues to reduce forward guidance, part of that historical decline could reverse further. For CPI, inflation surprises had an unstable impact on front-end rates before the pandemic, but the impact strengthened significantly after the pandemic, and inflation may still remain a policy focus under a Warsh framework. Accordingly, the report maintains a long position in 2y10y volatility through long straddles.

Analysis framework

The report measures market sensitivity by regressing the relationship between economic data surprises and changes in US 2-year Treasury yields. Economic data surprises are standardized by a two-year rolling standard deviation, while yield changes are standardized by three-month realized volatility, allowing comparison across Fed chair tenures. The report examines NFP and CPI separately and cross-validates using daily yield changes and intraday yield changes within 60 minutes after the data release.

Methodology notes

• Macro rates strategyEconomic data sensitivity regression

  Use standardized economic data surprises to explain standardized changes in 2-year US Treasury yields

  This method measures how large a rate reaction a given data surprise triggers, thereby assessing the degree of market data dependence under different Fed communication regimes.

• Historical scenario comparisonComparison by Fed chair periods

  Estimate market sensitivity separately across the Greenspan, Bernanke, Yellen, and pre-/post-pandemic Powell periods

  The Greenspan era is treated as a reference period with less forward guidance; if Warsh reduces forward guidance, that period can provide a historical upper-bound reference for a potential rebound in sensitivity.

• Market microstructure validationIntraday reaction in the 60 minutes after data release

  Use yield changes within 60 minutes after the 8:30 a.m. economic data release to test the direct shock

  The intraday window helps remove interference from other same-day factors, and the results are consistent with the daily data: after the pandemic, the impact of both employment and inflation surprises on rates strengthened.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• 2y10y straddle

  Core recommended trade

  Strengths

  Benefits from rising data sensitivity and higher short- to medium-dated rate volatility; the report also believes structural mortgage hedging demand and reduced callable bond supply provide support.

  Weaknesses

  The trade may suffer if volatility declines materially while rates remain near the strike.

  Comparison

  Compared with directly betting on the direction of rates, the straddle more directly expresses the view of rising volatility and large swings on data release days.

  Risks

  Volatility declines, rates trade in a range, insufficient magnitude of economic data surprises.

• 1y1y F/F+25/F+50 payer ladder

  Maintained secondary trade recommendation

  Strengths

  The recent rate selloff and rise in volatility provide a relatively attractive entry window for the payer ladder.

  Weaknesses

  The structure is relatively sensitive to the path of rates and how inflation shocks materialize.

  Comparison

  Compared with the 2y10y straddle, this trade is more geared toward expressing upside tail risk in rates and the risk of renewed Fed hikes.

  Risks

  If energy-driven inflation becomes persistent and forces the Fed to hike, the path could affect trade performance.

• US 2-year Treasury yield

  Object used to measure market sensitivity

  Strengths

  Front-end rates react directly to monetary policy and macro data surprises, making them suitable for measuring the impact of changes in Fed communication.

  Weaknesses

  Daily yield changes may include market factors beyond the data release itself.

  Comparison

  The report uses both daily and 60-minute intraday windows; the intraday window better isolates the direct impact of NFP and CPI.

  Risks

  Limited sample period, and major differences in macro environments across Fed tenures.

• Short-dated US rate volatility

  Primary beneficiary asset class

  Strengths

  With less forward guidance and greater data dependence, rate volatility around key data releases may increase.

  Weaknesses

  Longer-term volatility ultimately still depends on the actual magnitude of future economic data surprises.

  Comparison

  The report believes short-dated volatility benefits first, followed by medium-dated option tenors.

  Risks

  Mild economic data surprises, policy communication becomes clearer again, the market has already fully priced higher volatility.

Key data

• NFP sensitivity trendIn the pre-pandemic Powell period, roughly half of the Greenspan periodThe report states that the 2-year US Treasury reaction to the same NFP surprise fell markedly from the Greenspan period to the pre-pandemic Powell period.
• Potential sensitivity rebound magnitudeUp to about 0.5x daily volatility per unit of data surpriseIf the decline in sensitivity since Greenspan were fully reversed, the report estimates sensitivity could rise to this magnitude.
• NFP 60-minute reaction: Bernankebeta 1.11, R^2 0.60, t-stat 3.23Intraday data show that in the Bernanke period, NFP surprises had strong explanatory power for 2-year yields.
• NFP 60-minute reaction: pre-pandemic Powellbeta 0.38, R^2 0.24, t-stat 2.67NFP sensitivity was lower in the pre-pandemic Powell period.
• NFP 60-minute reaction: post-pandemic Powellbeta 0.81, R^2 0.22, t-stat 4.50NFP sensitivity rebounded after the pandemic.
• CPI 60-minute reaction: post-pandemic Powellbeta 0.79, R^2 0.35, t-stat 6.09After the pandemic, the impact of CPI surprises on front-end rates strengthened significantly.
• Trade recommendationBuy 2y10y straddle, entry level 670c, entry date 6/10/2026The rationale is that 2y10y expectations are supported by structural flows such as mortgage hedging demand, while callable bond supply has declined.
• Callable bond issuanceJune issuance has slowed seasonally; coupons on 6-10 year supranational bonds have risen toward about 5%Higher coupons provide healthier spread compensation relative to US Treasuries of similar maturities.
• Skew signalThe 21-day change in 3m10y skew has fallen back close to zero, with a signal around 30% of the maximum short-duration exposureThe recent rebound in long-end rates has been accompanied by skew normalization.

Impact & implications

If the Fed reduces forward guidance, the rates market may experience larger swings more frequently around key macro data. The investment implication is that short-dated rate volatility should find stronger support, with medium-dated option tenors potentially following higher afterward. For investors, the report recommends holding a long rate volatility position through a 2y10y straddle, while also watching whether CPI may matter more than employment data in near-term policy pricing.

Risks

• If the Fed under Warsh does not continue reducing forward guidance, the increase in market sensitivity may be smaller than expected.
• If future surprises in key data such as NFP and CPI are limited, longer-term volatility may not rise significantly.
• Historical analogies have limitations, as macro environments, inflation backdrops, and policy tools differ across Fed chair periods.
• Regression estimates are constrained by sample size, and confidence intervals are wide in some periods.
• If rates remain near the strike and implied volatility falls, a long straddle may lose money.
• The trade recommendations involve interest rate derivatives, which may not be suitable for all investors and are affected by liquidity, the volatility surface, and carrying costs.

What to watch

• Whether Warsh's subsequent FOMC press conferences and speeches continue to reduce guidance on the policy path.
• Whether intraday and daily reactions in 2-year US Treasury yields after NFP and CPI releases continue to strengthen.
• Whether short-dated rate volatility and medium-dated option tenors rise in tandem.
• Changes in dealer gamma distribution at the front end and long end, especially if the long end remains short gamma.
• Whether callable bond issuance and vega supply continue to decline, thereby supporting rate volatility.
• Changes in 3m10y skew and the corresponding duration signal.
• Whether inflation remains the primary variable in the Fed's policy reaction function.