Great Chart: US Yield Curve vs. VIX (log, 30M lagged)

As a response to the recent surge in the market’s volatility (VIX), we saw lately an interesting chart that plots the 2Y10Y yield curve overlaid with the VIX (log, 30-month lagged). Even though we don’t necessarily agree with the fact that yield curves are a good predictor of recessions, we like to integrate it in our analysis as a supportive argument when presenting our outlooks as it summarizes a lot of information in a single chart. Previously, we presented the SP500 index versus the 2Y10Y yield curve (here), in which we emphasized that US equities can continue to rise (as the fundamental indicators) for weeks (2000) or months (2006/2007) despite a negative yield curve.

In this chart, we can notice another important factor, which is that the bull momentum in the equity market can persist even though market experiences an increase in price volatility (on an implied base). For instance, in the last two years of the 1990s (98/99), the VIX averaged 25%, 10 percent higher than in the last few years, while the SP500 was up 70% (the Nasdaq actually increased by 100% in the last quarter of 1999).

Hence, if we assume that the 25-year relationship between equity volatility and the business cycle holds on average, the constant flattening US yield curve over the past 2 years was suggesting a rise in the VIX.  The chart shows the persistent divergence between the two times series prior the sell-off; while the 2Y10Y had flattened by 200bps to 0.50% over the past couple of years, the VIX was averaging 10-12. The question now is: what to expect in the future for US equities, volatility and yields?

With the 10-year slowly approaching the 3-percent threshold, are US equities and volatility sensitive to higher long-term yields? As Chris Cole from Artemis pointed out in his memo Volatility and the Alchemy of Risk, there is an estimated 2tr+ USD Global Short Volatility trade (i.e. 1tr USD in risk parity and target vol strategies, 250bn USD in risk premia…). Can we experience another late 1990s period with rising LT yields, higher implied volatility without a global deleveraging impacting all asset prices?

In our view, it is difficult to see a scenario with rising LT yields combined with an elevated volatility (i.e. 20 – 25 %) without a negative impact on overall asset classes. Hence, if we see a persistent high volatility in the medium term as this chart suggests, the deleveraging in both bonds and equities by investment managers will kickstart a negative sell-reinforcing process, creating a significant sell-off in all asset classes with important outflows in the high-yield / EM investment world, hence leading to a repricing of risk.

Chart. US 2Y10Y Yield Curve vs. VIX (log, 30M lagged) (Source: Eikon Reuters)

USYield vs VIX

Great Chart: Relative Implied Volatility – VIX/RVX ratio

For each investor, there are several ways of measuring the market’s temperature. For instance, former Fed chairman Alan Greenspan would look at the 10-year US yield, some investment managers will simply look at the VIX and currency traders will tend to watch the moves on the Japanese Yen, especially against the US and Australian Dollar (see AUDJPY and SP500 correlation here). We know empirically that a sudden move on the Yen (JPY appreciates relative to other currencies) is usually accompanied with an equity correction and hence an increase in the implied volatility. Even though we hear a lot about the VIX measure, we also need to pay attention to the implied volatility surface, presenting skew/smiles features and term structure, and compare it relative to other equity markets and asset classes. For instance, a couple of measures we like to watch are the VIX/Skew (here) and the VIX/VXV (here) ratios.

Hence, in today’s article, we present the VIX/RVX, which measures the ratio between the implied volatility of the SP500 and the Russell 2000, a small-cap stock market index. As you may know, the ‘small cap premium’ has been a crowded study in the empirical academic research, which started from the early work of Rolf Banz (1981) who founded that ‘smaller firms have had higher risk-adjust returns, on average, than larger firms’. Then, in their paper The Cross-Section of Expected Stock Returns (1992), Fama and French found that value and small cap stocks, on average, outperform growth and large carp stocks. As you can see it on the chart, an interesting development has occurred over the past few days following the huge spike in volatility. The VIX/RVX, which has constantly been above parity since 2006, is now sitting at 0.83. In other words, according to the index, the Russell 2000 equity market carries less risk than the SP500. The question now is: what explains this sudden drop in the ratio?

If we look at the week-on-week change in both indexes, we can first notice that, at current levels, the WoW change of 11.6 in the VIX came in at 5th position in the index history, just a 0.3 ‘shy’ of the October 1997 move (here). However, if we now look at the change in the implied volatility of the small caps, the RVX index barely changed (+2.3) over the past week, meaning that the drop in the ratio was only coming from the VIX move (here).

Hence, this leads us to an interesting conclusion: it seems that there is much more financialization going on with the VIX than with the RVX, either through the creation of single and double-levered long and short VIX ETFs products, or from a volatility-targeting and risk-parity perspectives (are those strategies more oriented towards the SP500?).

Chart: Relative Implied Volatility – VIX / RBX ratio (Source: Eikon Reuters)