Will volatility stay high?

The volatility on bonds is at Eurozone crisis levels, though has yet to scale financial crisis peaks and has not been transmitted to equity markets

Volatility is in the air, nowhere more so than in Eurozone bond markets — German 10yr yields had risen from 0.05% in mid-April to 1.05% last Wednesday, only to fall back to 0.83% on Friday.

Heightened volatility brings buying opportunities (it is rarely associated with strong markets). The rise in yields caused us to last week increase the holdings of government bonds (and cash) in the Source Multi Asset Portfolio, even though we remain decidedly underweight sovereign debt (and IG corporate debt which we reduced to zero).

Before congratulating Mario Draghi on his ability to predict markets, it is worth remembering that in this case he had inside information. In our view, yields in the Eurozone have been distorted by ECB purchases and it is not surprising that volatility spiked as investors eventually reacted to both the low yields on offer and the improvement in data flows (when yields are so low, there is no safety net). Will the volatility last?
Figure 1 shows how government bonds have indeed become more variable. Volatility has returned to the highs of the Eurozone crises of 2010-12 and exceeds that of the taper tantrum. Thankfully, it has not yet scaled the heights of 2008-09 and has not been transmitted to equity markets (the volatilities of the two asset classes are normally correlated).

Interestingly, those earlier spikes proved relatively short-lived, with volatility settling back at the lower base that has existed since the financial crisis. If you think low yields are enough to cause a prolonged volatility spike, take a look at what happened in the US. The Fed was every bit as aggressive as the ECB in its asset purchases (as a share of GDP) and real yields in the US went as low as did those in the Eurozone a few weeks ago. US yields may have ebbed and flowed but volatility did not remain high. Even the taper tantrum did not have a durable effect, not surprising given our earlier finding that volatility across most asset groups tends to be depressed when the Fed is tightening.
Figure 2 helps explain why. It suggests that volatility tends to rise when the economy and payrolls are weak. Conversely, when the economy and payrolls are strong, volatility tends to be low. It is exactly during these periods of economic strength that the Fed tightens. On this basis, the conditions do not appear ripe for a sustained rise in volatility. Bond yields may continue to fluctuate but not at the rate seen in recent weeks, in our view.

That said, no two cycles are ever the same and we should look for reasons why volatility might rise in the immediate future. One flippant point is that volatility tends to be seasonal. Our analysis of monthly averages of the VIX since its inception in 1990 shows that spring and early summer tend to be associated with the lowest levels of volatility (typically 18-19), while September-November tend to be the most volatile months (21-23, on average). Enjoy the summer!

A more fundamental difference between now and the past could be the exceptional policy setting environment. On our estimates, taking account of interest rates and asset purchases, current Fed policies equate to a -5% interest rate. As the Fed and other QE central banks raise rates and run down the size of their balance sheets, it is hard to know what the effect will be on markets.

Our best guess, however, is that volatility will not durably rise until the US economy rolls over into recession. That eventuality does not strike us as being just around the corner, so we would use periodic bouts of volatility (Greece, seasonal patterns etc) to buy cheap assets. We prefer to sell when volatility is low and seek opportunities when it spikes.

Paul Jackson (Head of Research), András Vig – Source