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When High Volatility Comes With Low Rates

Submitted by Helen Thomas via Blonde Money blog,

So far, volatility has moved from FX markets into equities, as Blondemoney warned in mid-September, but the bond markets had been relatively well behaved. The white line in our cross-asset vol chart is only just starting to tick up, while the equity measures veer off into panic territory:

 

That equity market panic is feeding into lower bond yields in a classic “flight to safety” way. This price action might feel reassuring to investors. After all, when bonds and equities were rallying at the same time, something didn’t feel right. Now they’re moving in opposite directions, there’s a sense that it makes more sense. However the comfort is likely to be short lived. We might miss the greater dangers if we’re looking at the wrong measures, as discussed in what happens when vol eats itself.

It’s generally considered that higher volatility in bond markets would accompany higher rates. Thus, if rates are falling, volatility will remain subdued. Certainly if you look at the correlation between the US 10 year yield, and the MOVE index (the measure of US Tsys 1month implied option volatilities), there’s usually a positive relationship. i.e. when yields go up, vol goes up. Here’s a chart of the correlation over the past 4 years:

But of course, the past 4 years may not be the best representative sample. As we know from the financial crisis, at times of stress, ‘unusual’ things can happen. As the CFO of Goldman Sachs said in 2009, what happened to financial markets then was a ’6 sigma event’ – it looked like something almost impossible in terms of standard deviations (or sigma for those who fell asleep during the greek bit of their statistics class). Yet it still happened. Here’s the same chart for the financial crisis period:


Now the line is downward sloping – there was indeed a negative correlation, where lower yields led to higher volatility.

Even if you don’t like statistics (and even Blondemoney was forced to write her A Level Stats project on Manchester Utd results to make it palatable), the intuition is clear. If you’re in a more stressed or panicked environment, the flight to safety is so strong that bonds are bid, their yields fall, but volatility goes up.

Now, Blondemoney is an optimist, and doesn’t for one second think we’re in a Lehman redux. In fact, once the dust has settled on the current panic, the market will realise that these kinds of corrections are normal, that volatility is back, and that that’s OK. But we’re not there yet. We’ve all been worried about a bond market blow up for some time. Even the RBA Assistant Governor Debelle warned last night with specific reference to the fixed income market that “The lower liquidity is not evident in a rising market when assets are being bought, but will quickly become apparent in a down market as investors try to exit their positions”. But what if, as Albert Edwards said, the poor liquidity manifests itself in falling yields?

As the PIMCO Eurodollars liquidation showed, the market was already short. So the position liquidation is coming in a rally, rather than a sell-off. On top of that, inflation is falling and with oil under pressure should remain low. Meanwhile the Fed hawks evidently lost the argument to the doves in September, and their hand has been strengthened by the dollar rally. So the conditions are set for higher vol to accompany the fall in rates.