Until the equity market’s abrupt correction in late January, Treasury options were in a state of deep slumber, with volatility near record lows for 2Y, 5Y, 10Y and 30Y Treasuries. Over the past month, Treasury options volatility has staged a mini-spike that seems significant by recent standards (Figure 1) but is unremarkable when viewed from the longer-term perspective of Merrill Lynch’s “MOVE” index (Figure 2). Even after the recent break out, volatility in Treasury options remains much closer to historic lows than to its average levels. The record highs of 2008 are a distant memory.
Even so, volatility in Treasury options, could escalate for three reasons:
During the great expansion of the Fed’s balance sheet from 2009 to 2017, Treasury markets could always count on a reliable buyer. During the three QE phases, the Fed bought roughly three trillion dollars of U.S. Treasuries –over 20% of the total. Once QE ended in 2014, the Fed continued to reinvest 100% of the principal of maturing bonds. Since October 2017, the Fed has reduced its bond buying, shrinking its balance sheet. This will push more Treasuries to the private sector, reducing bids on bonds.
In parallel with the Fed’s buying program, Federal budget deficits became much smaller from 2009 to 2016, declining from 10.2% of GDP in early 2009 to just 2.2% of GDP by 2016. The decline in Federal debt issuance was due to three factors: 1) economic recovery, 2) the expiration of previous tax cuts, and 3) reduced spending growth following budget sequesters (Figure 3). As such, just as the Fed ramped up its buying, the Treasury Department scaled back sales.
With the Fed buying fewer Treasuries and the government issuing far more of them, there is a strong potential for volatility to rise and to reawaken the market from its QE-induced slumber. When the Fed buying was brisk and the Treasury selling slow, there wasn’t much downside to owning government bonds. Upside may have been a worry but downside seemed (and apparently was) limited. Indeed, Treasuries performed well from 2009 to 2017 even as the S&P 500® quadrupled in value.
Recently, however, the opposite has been true. Equites fell as much as 12% after hitting their high on January 25 and bonds not only didn’t rally, they actually sold off. Yields were over 25 basis points (bps) higher on March 9th than they were on January 25 despite an equity market that was still trading off its highs. So much for flight to quality.
Not only has the Fed reduced its buying as the Treasury has stepped up its selling, the Fed is also raising rates. The Fed’s dot plot suggests three rate hikes this year and an additional three rates hikes in 2019. Over the past few months markets have come to believe the dot plot, at least in part.
Fed Funds futures still aren’t entirely on board with the idea that the Fed will hike rates three times in 2019 year (Figure 4) but they do price three rate hikes for 2018. Fed rate hikes will expand the budget deficit by raising the government’s cost of issuance, insuring a somewhat greater supply of debt. Moreover, if the Fed hikes as often as the market is pricing potential hikes, it will probably succeed in flattening the yield curve a great deal further and, the flatter the yield curve, the more likely the fireworks are about to begin.
Our past research has pointed out a strong relationship between the slope of the yield curve (30-year Treasury yields less three-month bills) and the level of volatility in the market. Our first paper on the subject covered the phenomenon for the VIX, an index of options on the S&P 500®. The same logic applies to credit markets, unemployment and also Treasury options. Because it has such a long history (since 1988), we use the Merrill Lynch MOVE Index of 1-month options on the weighted average of volatility 2Y, 5Y, 10Y and 30Y U.S. Treasuries.
Both VIX (S&P 500®) and MOVE (Treasuries) move in a four-stage cycle with respect to the yield curve:
Notice how Treasury and equity index option volatility have moved in tandem since 1999 (Figures 5-8).
Curiously, the nice counterclockwise motion that we see in the yield-curve volatility cycle only worked for equity index options during the 1990s (Figure 9) and not for Treasury options (Figure 10). The clockwise motion (rather than counterclockwise motion) of the Treasury options over the course of the 1990s may be due in part to the enormous volatility shock created by the Fed’s 1994 tightening cycle, which caught the bond market completely off guard. At the time, the Fed was much less inclined to signal its intentions in advance. This is a sharp contrast to the 2004-2006 period and to the current tightening cycle for which the Fed carefully prepared the markets well in advance. Moreover, during the 1990s, bond market investors were much more afraid of a return to 1970s-like inflation than they are today. Now investors believe that tightening labor markets won’t necessarily result in runaway consumer price inflation – a conclusion that many would have found surprising 20 years ago. At the time, low and stable inflation was a new phenomenon that was neither understood nor trusted.
The exciting pop in volatility in late January and early February 2018 notwithstanding, the 150 bps of steepness between 3M and 30Y rates may be enough to keep a lid on volatility for a while longer. Treasury and equity index options volatility may have awakened but that doesn’t mean that they won’t go back to sleep for a while longer. That said, if the Fed hikes anywhere near the 150 bps that its dot plot chart suggests over the course of 2018 and 2019, the likelihood is that the yield curve will be flat by late next year and volatility might head towards a major explosion early in the next decade. In addition, the monetary, budgetary and cyclical aspects of volatility aside, there is one other reason to think that Treasury options volatility might be heading towards a major eruption: valuation.
The S&P 500® has rallied over 300% from its March 2009 low. At 125% percent of GDP, the S&P 500®’s market cap is closing in on its post-WW II high of 138% of GDP set in 2000 and is well above peak levels from the 1960s (Figure 11). In the past when its market cap hit such lofty levels relative to GDP, returns going forward were not good. After hitting nearly 110% of GDP during the early-to-mid 1960s, stock prices stagnated, in nominal terms, for a decade and a half. Adjusted for inflation, the picture was much worse: between 1966 and 1982, the equity market fell 70%. Likewise, the market fell with similar ferocity between 2000 and 2009, with back-to-back 50% and 60% drawdowns punctuated by a four-year recovery in between.
One feature apparent in Figure 11 is the strong inverse relationship between the level of 10-year Treasury yields and the ratio of S&P 500® to GDP. When bond yields are high, equities tend to trade at low ratios relative to GDP. By contrast, when bond yields are low, equities can support much higher GDP ratios.
Given the combination of historically low bond yields and historically high equity-to-GDP ratios, are the markets in a bond bubble, an equity bubble or a generalized equity-and-bond bubble? The truth is that we don’t really know. That said, consider the following simple metric and the rather decisive answer it provides to the question above: one can multiply the S&P 500®/GDP ratio by the 10-year U.S. Treasury yield. (We chose 10-year bond yields because they have a longer history than 30-year bonds, which only date back to 1977). This is akin to the so called “Fed Model,” which multiplies price earnings ratios by bond yields. The line in Figure 12 results from multiplying the data series in the black and blue lines in Figure 11.
This graph strongly suggests that if there was a bubble, it wasn’t an equity bubble but rather a bubble in government debt. How this plays out as the Fed unwinds QE and raises rates simultaneous to a vast expansion in the Federal deficit will be interesting to watch, to say the least.
The expansion of central bank balance sheets and the presence of extremely low interest rates appear to be behind many key features in the current financial environment, including extremely low bond yields, high equity/GDP ratios and the new record lows in implied and realized volatility across many different markets (currencies, equities, bonds and metals). To the extent that this is true, this should make all market participants nervous about the consequences of the Fed raising rates and reducing the size of its balance sheet. The virtuous cycle of low yields encourages low volatility, and rising equity valuations could go into reverse gear at some point with higher bond yields, provoking a disorderly equity sell off and a flight to quality with explosive upside potential for implied volatility on both Treasury and equity index options.
Thankfully for those who are positioned to profit from a continuation of the current financial environment, other central banks, such as the European Central Bank (ECB) and the Bank of Japan, are still expanding their balance sheets, albeit at a reduced pace. By lowering their own domestic bond yields they are forcing their investors into riskier and higher yielding investments, including U.S. Treasuries. Even so, as the ECB draws its quantitative easing to a close by the end of 2018 and other central banks, including the Bank of England, look towards tightening monetary policy, investors shouldn’t be excessively complacent.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author(s) and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.
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