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)