What can’t the yield curve predict?
Not only has an inversion of the Treasury yield curve — a line plotting yields across all Treasury maturities that under usual circumstances slopes upward — sparked recession fears, it ends up that a prolonged shift to a flatter profile also portends a renewal of price volatility for stocks and other assets, according to Alan Ruskin, global macro strategist at Deutsche Bank.
Read: The yield curve inverted — here are 5 things investors need to know
That’s a relief for traders and active asset managers who can profit when prices are more volatile, offering increased opportunity. After a rise late last year as stocks suffered a significant year-end rout, measures of volatility across asset classes have returned to subdued levels. Indeed, the post-financial crisis environment has been characterized by low volatility, which market watchers have attributed to the flood of monetary stimulus by global central banks and other factors.
See: The stock market often produces its strongest returns after yield curve inverts, notes top quant
But Ruskin hears a bugle in the distance.
“Fear not, ‘the vol cavalry’ are finally coming. Who says so? The yield curve,” he said, in a Wednesday note. It ends up that the yield curve is very strongly correlated with all the usual measures of stress, including the VIX, the Cboe Volatility Index VIX, -1.52% an options-based measure that illustrates expected S&P 500 SPX, +0.22% volatility over the coming 30-day period (see chart below).
Deutsche Bank
It also correlates with other volatility measures, like Deutsche Bank’s own gauge of realized forex volatility, and the MOVE index, which measures bond-market volatility. Ruskin said it also tracks well with measures of financial conditions like the Corporate BAA-U.S. Treasury 10-year credit spread.
“In all cases, the message is fairly simple — the ‘vol cavalry’ are indeed coming, but they have had a long ride in, for the yield curve typically leads the…vol measures by close to three years,” he said. Indeed, the typical lag between the 10-year/2-year yield curve and the VIX is 33 months, while bond and currency volatility lag by 36 and 40 months, respectively.
For those that view volatility as synonymous with trading opportunities, those long lags aren’t as worrisome as they may sound, Ruskin said. He noted that the curve has been trending flatter since 2014. That means “we should already be ‘over the hump’ whereby the curve is increasingly associated with a pickup in vol.”
The VIX stood at 15.28 on Thursday, up 0.13 point, but well off its late-December closing high of 36.07 set on Dec. 24, a day that saw stocks notch their worst ever pre-Christmas trading session and marked the low of the December rout. The VIX’s long-term average is above 19, but has spent long periods at well below average levels in recent years. The S&P 500 has roared back 19% from its Dec. 24 low.
So why does a flatter curve portend volatility? It’s because flattening tends to lead growth slowdowns, which are themselves associated with an increase in volatility.
“In this way, rather than attributing direct causation, it could be that the yield curve is a good leading indicator of the growth cycle, and it is growth that may be more directly causing/influencing volatility,” Ruskin said. “In this instance, the yield curve predicts a slowdown, and the slowdown breaks the normal recovery phase, and that this break from stability creates the market stress.”
Of course, it’s possible that the currency cycle is different. Interest rates across major economies remain extremely low, which means that adjustments in policy rates will be modest, limiting the potential for big moves in rate spreads, which are the “bread and butter” of currency volatility. Other policy measures, including the Bank of Japan’s yield-curve control program are a “direct attack” on bond volatility, he said.
At the same time, constraints on central banks’ rate policy and the limited degree of freedom that gives policy makers scope to respond to economic events can also be a source of volatility, he said, which should be encouraging for riskier assets like equities and emerging market assets and currencies.
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