What, if anything, can yield spreads between the 3-month T-Bill and the 10-Yr Treasury bond tell us about the future path of equity market volatility? Quite a lot, actually.
Using monthly historical data on 3m/10y spreads and the VIX going back to September 1992, there is a decent inverse statistical relationship between the spread level in a given month and the level of equity market volatility approximately two years later.
Why would this occur? Generally, Federal Reserve interest rate policy decisions operate with a lag of one and half to two and a half years. Wide spreads, i.e. much lower short rates compared to the long end of the Treasury curve, are generally associated with accommodative Fed policy. With a lag, one might expect economic activity to pick up 18 to 24 months after the policy shift. Low short rates and wide spreads influence credit creation, the life-blood of an economy, in various ways. Borrowers may be more apt to borrow with lower overall rates. With spreads wider, banks and others may be more encouraged to supply credit. The converse is also true. Hikes in the target Fed Funds rate over time are meant to dampen animal spirits and keep inflation tamed. Historically, the Fed has often moved short rates to a point where shorter rates on the Treasury curve actually exceed the level of rates at the long-end, a condition known as an inverse yield curve. Many prognosticators actually point to inverse yield curve situations as a reliable recession forecaster. Historically, various leading indicator indices have factored yield spreads into their calculations. Coming back to equity market volatility, periods of economic calm have generally been associated with equity market calm, while recessions, or serious decelerations in economic activity often cause serious market dislocations.
What does the historical data tell us? Statistically, the relationship between the VIX, an index constructed to represent implied volatility in S&P 500 equity index options (higher VIX levels indicate higher implied volatility and vice versa, hence its nickname, “The Fear Index”), and 3m/10y Treasury spreads is reasonably strong when using a 23-month lag. The correlation between the two over the past two decades is -0.605 and the R-squared is 0.37. Higher Treasury curve spreads have resulted in lower equity market volatility two years later and vice versa.
What about the current situation? The current monetary policy situation in the US makes the kind of Fed cycle rate cycle analysis referred to above somewhat more problematic. Since the beginnings of the financial crisis and Great Recession, the Federal Reserve has kept the Fed Funds rate near zero. The Fed can’t take the official Fed Funds rate negative, so the Fed has used unconventional policy such as quantitative easing (buying lots and lots of longer duration Treasuries) to keep rates tame on the longer end of the curve, ostensibly to encourage borrowing activity and general credit creation. As a result, shifts in the Treasury curve spreads have been more influenced by moves in the 10-year Treasury yield. Interestingly, except for the volatility flare-ups associated with the European credit crisis, an exogenous shock to the US markets, equity market volatility has acted very much in line with what Treasury spreads would have predicted over time. Since 1992, the overall average 3m/10y spread is 1.76% and the average VIX value is 20.4. From March 2009 to November 2011, the period of spread values that captures VIX values to the present time period, the average Treasury 3m/10y spread has been 2.98%, far above average (steeper yield curve, should produce lower volatility). The lagged VIX average corresponding to that Treasury range through month-end October 2013 has been 19.1. The median, which reduces the influence of the outliers associated with the European flare-ups, is 17.1. Since early 2009, US markets have risen, and the path of volatility has been downward, conditions that have been associated in the past with steeper yield curves.
What do Treasury spreads in recent months potentially tell us about the future path of volatility? Beginning in late summer 2011, 3m/10y Treasury yield spreads began moving downward reflecting the sharp move downward in the 10-year Treasury yield. While many would ascribe the move in the long-bond to QE, the overall move was probably much more related to market worries about the future path of economic activity. Between 12/30/2011 and 4/30/2013, the average Treasury yield spread was 1.69%, slightly below the long-term average. The 12/30/11 spread value corresponds to the November 2013 VIX value and the 4/30/13 spread value corresponds with March 2015. The VIX closed October at 13.75, very low historically. The average predicted VIX value for the 18-month period from this point forward is 21.23. If the model holds up, it may be time for equity investors to get prepared for normalization in equity market volatility over the coming year or two. This doesn’t mean that the equity markets are necessarily prepared to fly off the rails, or that the economy is prepared to collapse—again predicted vols are more in line with the historical average—it just means that the benign, boring market environment we’ve become accustomed to in the US has the potential to move back towards choppier waters in 2014.
