Any investor who’s been complaining about what a boring, sideways grind the market’s been this year is clearly looking only at U.S. stocks. The action and anxiety have all been in the bond and currency markets, where jumpy moves and surprising switchbacks have undermined these assets’ reputation for relative stability.
The question that’s starting to be asked more and more on Wall Street is: Will the volatility that’s been animating bonds and foreign exchange markets at some point migrate into equities? Or are the fixed-income and FX worlds simply experiencing their own private freak-out over diverging central bank policies and concerns over thin trading liquidity?
There are several ways to capture this unusual setup. Since the start of the year, the S&P 500 index (^GSPC) has traded in such a narrow range that its high and low are only 3.5% from the midpoint level. The price range for the popular ETF tracking long-term Treasury bonds, the iShares 20+ Year Treasury Bond fund (TLT), has been more than twice as wide. And even the US dollar index – the value of the dollar against a selection of other major currencies – has travelled a wider span than stocks have in 2015, as shown by the PowerShares DB US DOllar Index Trust (UUP).
Economists at Deutsche Bank tell a similar story using a chart of bond volatility that’s priced in to market – called the MOVE index – versus the VIX, which tracks market expectations for stock volatility. This ratio of bond-to-stock volatility has reached a post-financial-crisis high in recent weeks.
This isn’t the way it’s supposed to go over longer periods of market time. Stocks will tend to be more volatile on average. They are risky claims on future corporate cash flows, after all, while bonds are binding promises of repayment. That’s why bonds are typically used as a source of ballast in a portfolio. So what’s going on? It seems the main macro drivers of capital movement this year are expectations for when the Federal Reserve will “lift off” from its zero interest rate policy, how the European Central Bank’s quantitative easing program goes and whether Greece will stay in the Eurozone.
Government bonds and currencies are the things most sensitive to such concerns about the immediate and future cost of loans and trading capital. The jumpiness in bonds and currencies is also probably made more extreme by reduced liquidity in those markets, a result of stricter bank capital rules and the heavy presence of central banks as buyers of fixed-income paper.
The puzzle now - as yet another Greek-bailout flashpoint approaches and a US employment report helps determine the Fed’s plans – is whether stocks can continue to simply absorb the other asset market’s emotional moves without getting getting caught up in them.
The Deutsche Bank folks figure that one way or another, the volatility levels of bonds and stocks will converge again before long, either by bonds calming down or equities getting more excitable and nervous as policy shifts approach. Historically, of course, bond-market action leads stocks, and tends to be the more reliable indicator of what comes next.
One place this is all playing out in the stock market is the financial sector. Bank stocks have been relatively strong, helped by a lift in longer-term interest rates and decent economic performance. This is a net positive for the overall market - but of course bouts of financial-market volatility have often knocked big banks off balance in the past.
Is the banks’ reduced trading appetite making them a more calming investment even as the capital markets grow jittery? That would be a true irony of the post-crisis world, though not an unwelcome one.
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