The Death Of Bond Market Volatility

&l;p&g;&l;img class=&q;size-large wp-image-368&q; src=&q;×799.jpg?width=960&q; alt=&q;&q; data-height=&q;799&q; data-width=&q;1200&q;&g; Are the rest of the financial markets asleep?

When I say &a;ldquo;Jump&a;rdquo;, you say &a;ldquo;How high?&a;rdquo; That describes the relationship between the bond market and the stock market over the last ten years. Whenever there was a bout of equity volatility, which usually was associated with a sharp drawdown, investors could count on their safe-haven US Treasuries to offset some of the loss. Those days are gone.

Investors are slowly coming to terms with the change in correlation structure between the two markets: US Treasuries, especially short and intermediate durations, are losing their ability to rally when stocks sink. Why?

&l;strong&g;Increase in supply of risk-free assets&l;/strong&g;

Global central banks rescued the financial markets through quantitative easing (&q;QE&q;) after the 2008&a;nbsp;housing market crisis by purchasing a massive amount of government securities. Now that QE is reversing, the market needs to find new buyers for all the bonds. The new buyers are more price-sensitive than the Fed and are not so enthusiastic to purchase bonds with low or even negative real (inflation-adjusted) yields. Also, the amount of government supply is increasing. Thanks to tax cuts and other spending measures, the fiscal deficit is &l;a href=&q;; target=&q;_blank&q;&g;expected to top $1 trillion&l;/a&g; in 2019. The&a;nbsp;additional issuance will add fuel to the supply/demand imbalance. The scarcity of &a;ldquo;safe assets&a;rdquo; is no longer a factor, so bonds don&s;t react the way they used to when stocks fall.

&l;strong&g;More Fed rate hikes to come&l;/strong&g;

Supply and demand set the clearing level for longer-term interest rates, but short-term yields are largely dictated by central bank policy. If the overnight rate is rising, the yield on T-Bills, 1-year and 2-year fixed income instruments will move higher. The Fed Funds futures market is still predicting another two to three rate hikes by the end of the year. Why pile into 2-year notes as a safe haven when the Fed is still not done raising interest rates?&a;nbsp;Yes, the Fed could respond to stock market weakness by pausing on the path to higher rates, but they will only do so if the tighter financial conditions&a;nbsp;are anticipated to dent the real economy. A 10% drawdown from what many believed were overvalued levels would not meet that criterion. The Fed is not going to save equity investors from a garden-variety correction.

There is more to the story than just diverging directions between stocks and bonds. The correlation between equity and bond &l;em&g;volatility&l;/em&g; has also shifted. Volatility in one market historically has led to an increase in the other. Not this time around. The&a;nbsp;instability in financial markets has, so far, been isolated to the stock market.

One way to highlight the change in the two markets is to look at how much each market has moved since the start of the year. The difference is dramatic. 30-day realized volatility on the S&a;amp;P 500 has risen 357% since the beginning of January. High-grade bond volatility is up only 14%. NOBODY predicted that.

&l;img class=&q;size-large wp-image-367&q; src=&q;×603.jpg?width=960&q; alt=&q;&q; data-height=&q;603&q; data-width=&q;1200&q;&g; Equity volatility has exploded. Bond volatility has not.

So which one, if either, is out of line? The recent stock market volatility is lofty, and not just compared to the abnormally low levels of 2017. Current 30-day realized volatility at 21% is at the higher end of the 5-year historical average of 12%. The Bloomberg Barclays Aggregate Bond Index, on the other hand, has a current 30-day realized volatility of 2.6%, close to the 2.8% average level over the last 5 years. If you were to look at recent history as a guide, you would conclude that equity volatility is the anomaly.


&l;img class=&q;size-large wp-image-366&q; src=&q;×603.jpg?width=960&q; alt=&q;&q; data-height=&q;603&q; data-width=&q;1200&q;&g; The increase in volatility is a US phenomenon, not a global one.


An interesting development, though, is that the surge in realized equity volatility is mostly a U.S. market phenomenon. One of the chief reasons stocks are moving so violently is the potential for the trade spat to turn into a trade war. This, theoretically, should increase global macro uncertainty. So why are international equity markets, especially emerging markets, not experiencing the same gyrations? The 30-day realized volatility in emerging markets is only 66% higher since the beginning of the year, compared with the 357% jump for the S&a;amp;P. At least there are some explanations why the bond market is quiet in comparison, but it is hard to comprehend why the macro-sensitive emerging markets are not more skittish.

One answer could be that the U.S. equity market was too complacent coming into 2018 and is still recovering from the VIX technical in early February. After all, 2017&a;nbsp;was one of the lowest volatile years on record: there was a strong trend that provided more than a 20% total return, but the daily swings were minuscule. 2018 is proving to be the exact opposite. The year-to-date return of the S&a;amp;P is down just 2%, but the daily volatility is huge.

The divergence&a;nbsp;in&a;nbsp;volatility of different financial markets is unsustainable. Two scenarios are possible&a;nbsp;from here. Either the S&a;amp;P 500 will work off this technical adjustment and revert back to&a;nbsp;lower day-to-day moves, or other asset classes and other equity markets will wake up and realize something bigger is going on. My bet is on the latter.&l;/p&g;

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