Bond and Stock Markets Brace for Surge in Volatility
Increased volatility is anticipated in the US interest rate and bond markets as they realign with fundamental factors. This shift is expected to lead to higher interest rates and increased stock market volatility, particularly affecting sectors like technology that have longer-duration assets, potentially resulting in underperformance and downside risks.
Currently, there's a sense of unusual calmness prevailing in bond markets. Despite looming risks of economic growth and inflation, bond market volatility has been decreasing over the past six months, remaining significantly lower than the peaks seen in 2022 and the turbulence experienced during the SVB crisis in 2023.
However, there are emerging indications suggesting that this period of low volatility won't persist for much longer. We might soon witness more significant fluctuations in bond yields, primarily in an upward direction. Consequently, the currently subdued VIX (a measure of stock market volatility) is expected to rise again, signaling a resurgence of volatility after a period of quietude.
Historically, periods of low or declining volatility have often preceded substantial market movements. A pertinent example is the decline in volatility for gold and silver preceding recent surges in their prices.
The MOVE index, akin to the VIX but for the bond market, has experienced fluctuations corresponding to shifts in interest rates. While it surged during the Federal Reserve's rate hikes and the SVB crisis, it has since declined, which seems at odds with the prevailing risks in the market.
While much attention has been focused on slowing inflation, indicators suggest rising volatility in inflation, which is concerning for bond market stability. Moreover, the real yield curve, which typically flattens during periods of declining inflation, has not followed this pattern, signaling underlying market uncertainties.
Despite growing inflation risks, implied short-term interest rate volatility has decreased, suggesting a lack of concern compared to historical norms. However, given the current economic landscape, this decrease may not be warranted.
Bond markets are facing both inflation and growth-related risks, with markets seemingly more concerned about the latter. This is reflected in declining implied bond volatility despite rising realized volatility in yields.
As inflation risks continue to rise, volatility in real yields is expected to increase, amplifying nominal yield volatility. This could lead to stress in bond markets and subsequently impact stock market volatility.
Stock market volatility is expected to rise alongside bond market volatility, primarily driven by changes in equity index correlation. The current low correlation between stocks has been keeping the VIX subdued, but any increase in bond volatility could quickly reverse this trend, leading to higher stock market volatility.
Higher volatility in equities could destabilize the stock market, particularly affecting high-duration sectors like technology. However, hedging strategies in the stock market are currently relatively inexpensive, providing some level of protection for investors.
In conclusion, while it may seem calm for now, the bond and equity markets are potentially entering a period of increased volatility and uncertainty, suggesting the need for caution and preparedness among investors.