Equity volatility might seem to have little to do with the level or shape of interest rates, but after a bit of exploration we might be able to draw some solid conclusions. In a recent post I looked at the current record steepness of the yield curve and suggested that it might be a prelude to rising nominal values as it was in 2003. Now it is time to take it a step further and see what it means for equity volatility. The argument is that a steep yield curve means that longer term rates are suggesting higher growth and/or inflation in future years. If this does not make immediate sense to you, then please read a very popular post that outlines the components of interest rates. The other piece of this argument is that when the yield curve is steep, this usually means that short-term interest rates are being kept artificially low by the federal reserve. We often call this “easy money” because the cost of borrowing is low, but another way to think about it is that you earn zero or very low yields for holding cash and short-term investments. This usually forces institutions and individuals to chase risk, meaning that they push credit spreads tighter and equity markets higher as they search for yield and total return performance. With this as the underlying argument, does it hold any water?
The correlation has been consistent
Every type of financial analysis must be questioned and can only serve as one piece of an investment puzzle, but in this case and under this premise it would seem that the steepness of the yield curve would suggest much lower volatility levels in the future. The aspect that cannot be accounted for in this rather short history is the scale of the market dislocation during the credit crisis. We can only look back to the great depression to find an analogous period and option markets were hardly developed.
Posted in Economics, Markets, Technical Analysis, Trading Ideas.
Tagged with equity volatility, implied volatility, option volatility, treasury rates, vix, volatility interest rate correlation, yield curve shape, yield curve steepness.
By SurlyTrader
– March 11, 2010
A sobering perspective.
Posted in Media.
Tagged with bailouts.
By SurlyTrader
– March 11, 2010
Sheila Bair has to be given credit, she is working with a whole mess of financial institution failures that would give anyone nightmares. 168 failed institutions with more than $544B in assets have been seized by the FDIC in the last three years and there are 700 more “problem” institutions on the docket. To her defense, it is a bloody mess with residential foreclosure waves continuing to mount along with a commercial real estate storm that is just gaining momentum. What needs to be made clear is that the savior needs its own saving:
The FDIC's Funds have vanished rapidly
Regardless of the FDIC’s current financial situation, it has a lot of assets to swallow up in the near future:
$544B so far and $400B to go
This is not to say that $400B is all that the FDIC is left to deal with as there will be continuous financial pressure on regional and smaller community banks as they are forced to realize their losses. This does not mean that we should all scurry to distribute our cash to many financial instituions out of fear that the FDIC will not be able to back the assets, but that we should be watching to see how the FDIC gets its extra funding. To be sure, the government will be forced to backstop the FDIC just as they backstopped the large banks and the agencies.
What is interesting is that Sheila Bair is trying to utilize a solution that got us into the whole mess in the first place. Instead of selling the seized assets (and risks) from the FDIC’s balance sheet at fair market values (which are quite low), she is looking to securitize the seized assets and slap on an FDIC guarantee to assure investors. That’s right, take a pile of toxic waste and put a nice, shiny government guarantee on it. It did not work so well for MBIA and Ambac, but they did not have the luxury of tapping the taxpayers for some support. You can read about their devious plans at your own leisure.
Posted in Economics, Media, Politics.
Tagged with Ambac, bailouts, commercial real estate, failed banks, Fannie Mae, FDIC, financial failures, foreclosures, Freddie Mac, MBIA, mortgages, securitization, Sheila Bair.
By SurlyTrader
– March 10, 2010
Every few months I draw the spotlight on long-term US interest rates as they approach a long held barrier. Thirty year treasury yields have not been above 4.8% since the fall of 2007 but have tested the 4.7% level about 10 times since then. I consistently draw attention to long-term interest rates because they are intimately tied to housing affordability and the cost of servicing debt. The Federal Reserve can keep short-term interest rates low for prolonged periods of time, but they can only keep longer term interest rates suppressed for finite periods of time. In an economy burdened with debt, the level of interest rates are critical.
Testing the Rate Barrier Once Again
Interest rates have behaved the way that I predicted long ago, but now we are at a turning point. Is the rally real and can the economy actually sustain itself without government intervention? Those are the two questions that need to be answered in order to make a bet on equities or interest rates from here. If the growth does not materialize, expect choppy equity markets and range-bound interest rates. If a sovereign default or other large event risk pops up along with low to no growth, expect a retesting of the lows. If the government has ignited economic growth through low interest rates and stimulus, then we might just have a long way to go. For a hint on what might follow, I like to look at the steepness of the yield curve by comparing the 10 year treasury yield to the 2 year treasury yield. Since 1980, the steepness of the yield curve is at all-time highs:
The spread between 10 and 2 year rates seems to be a good rubber band gauge for the economy
When looking at the 10-2 spread, remember that the Fed controls the short end of the curve but has limited ability in moving the long end of the curve. When the yield curve is inverted or the spread is negative (shown in red above where 10 year yields are lower than 2 year yield) the market is saying that interest rates should be much lower than where the fed has them set which would imply less growth and less inflation going forward. When the yield curve is steep and the spread is highly positive as it is right now, the market is saying that the fed has short term rates way too low and there is going to be a larger proportion of inflation and growth (and now possibly sovereign default risk) than what short term rates are showing. I like to picture this as locking your front breaks while gunning the accelerator to spin your rear wheels; eventually you have to let go of the front breaks. Will I say that this spread dictates a high inflation rate in the next 4 months to come? No, but this signal has convinced me to increase my exposure to rising nominal prices and reduce my exposure to fixed interest rate bonds.
Posted in Economics, Markets, Trading Ideas.
Tagged with 10-2 spread, deflation, Federal Reserve, government intervention, inflation, interest rates, inverted yield curve, steep yield curve, treasuries, yield.
By SurlyTrader
– March 8, 2010
