Volatility Signals: Do Equities Forecast Bonds?

Shock, shock. Opposite to standard knowledge, the bond market could also be taking its danger cues from equities. No less than, that seems to be the case when fluctuations within the two main volatility indices are in contrast.

Fairness buyers usually look to the CBOE Volatility Index (VIX) as a gauge of concern or future uncertainty within the inventory market. In the meantime, fixed-income buyers depend on the Merrill Lynch Possibility Volatility Estimate (MOVE Index) to trace expectations of future volatility within the bond market. However which market units the tone for the opposite? Does one in every of these volatility measures lead the opposite, or are they merely reacting to distinct sources of danger inside their very own domains?

Difficult Assumptions: Proof That Equities Lead Bond

To reply that query, we examined how the VIX and MOVE indices have interacted over time, utilizing every day knowledge going again to 2003.

Our evaluation revealed a stunning consequence: whereas fluctuations within the MOVE index don’t predict actions within the VIX, adjustments within the VIX do assist forecast future strikes within the MOVE index.

This flips typical knowledge. Traders usually assume that the bond market, with its sensitivity to rate of interest expectations and macroeconomic alerts, units the tone for equities. However no less than with regards to market-implied future uncertainty, the connection seems reversed: the bond market is taking its cues from shares.

To discover this, we checked out how the 2 indices behave collectively. Over the past 20 years, they’ve usually moved in tandem, notably during times of macroeconomic stress, with a 30-day rolling correlation that averaged round 0.59. However correlation isn’t causation. To check for a predictive relationship, we used Granger causality evaluation, which helps decide whether or not one time sequence improves forecasts of one other. In our case, the reply was clear: the VIX leads.

Market Stress and Short-term Bond Management

Curiously, the sample shifts during times of elevated stress. When each the VIX and MOVE indices spike above their seventy fifth percentile ranges, indicating a high-volatility interval, we observe a reversal: the MOVE index reveals some predictive energy over the VIX. In these moments, equities seem to take cues from bonds. Whereas uncommon, this exception means that in instances of acute uncertainty, the standard move of knowledge between markets can briefly reverse.

One method to interpret these outcomes is that as a result of the MOVE index appears to take the lead during times of maximum uncertainty, bond managers are extra attune to large macro shifts within the financial system and seize large sentiment shifts higher than fairness managers (i.e., once we go from constructive to destructive momentum).

Implications for Multi-Asset and Hedging Methods

These findings might have essentially the most influence not for buyers that make investments solely in a single asset, however extra so for buyers which can be unfold throughout varied asset lessons. The outcomes spotlight that for multi-asset managers, with regards to assessing concern out there, it could be greatest to concentrate to the bond market when large strikes in concern or uncertainty change into obvious. However when coping with small actions within the notion of future uncertainty, the inventory market might surprisingly be the higher measure of danger to trace.

These outcomes even have robust implications for buyers who aren’t within the fairness market or the debt market, but use them to hedge danger. If a commodities dealer is in search of early indicators of massive strikes within the fairness market or bond market to get out of commodities, they could need to shift their consideration between the VIX and the MOVE indices as regimes transfer.

These findings problem a long-standing assumption: that the bond market at all times leads. No less than with regards to measuring future uncertainty, equities appear to set the tone, besides, notably, in essentially the most risky moments, when bonds regain their affect. It seems that, typically, the bond market is trying extra to the fairness marketplace for future assessments of danger somewhat than the opposite approach round. These outcomes benefit additional research, not simply into which market is main the opposite, however how this spillover of uncertainty travels between them.