The first quarter has witnessed a spectacular equity rally, despite stalling in recent days. During the same period volatility has plunged. The VIX Index, a measure of S&P 500 implied volatility, peaked at 36 shortly before New Year’s and traded as high as 27 on January 2nd. Since then, volatility has fallen by half, although it has started to bounce in recent days.
Why has volatility plunged?
As I’ve discussed in previous blogs, the best coincident factors when assessing volatility are forward looking economic expectations and financial conditions, best captured by credit spreads, i.e. the difference between riskier bonds and Treasuries. What is interesting about this year’s plunge in volatility: each of these factors is pointing in a different direction. Credit markets are healing, aided by a more dovish Federal Reserve, but economic data still suggests further softness ahead. Which one holds the key for volatility?
Historically, the clear winner has been financial conditions, quantified by high yield spreads. Not to say the economy does not matter. Since 1990 the Chicago Fed National Activity Index (CFNAI), a particularly good leading indicator, has explained approximately 25% of the variation in volatility.
That said, forward-looking measures of growth have been less relevant of late. One reason is that leading indicators are less useful when growth is stable, as it has been for much of the past decade. But even when growth is more varied, financial conditions typically display the stronger relationship. Since 1990 the level of high yield spreads has explained about 60% of the variation in volatility.
The economy, stupid–with nuance
Does this suggest that investors can ignore the real economy and focus solely on the Fed and financial conditions? The short answer is no, as the real economy still matters, just in more nuanced way. The level of expected growth seems to impact the strength of the relationship between financial conditions and volatility.
To quantify this impact it is worth looking at the historical relationship between monthly changes in high yield spreads and volatility. Since 1990, when high yield spreads rise the VIX climbs by an average of 8.50%. However, in those months when the CFNAI is below 0, suggesting sub-par growth, the spike in volatility has been more acute. Under these conditions, wider spreads are associated with an average monthly rise of 12% (see Table 1). In other words, when growth is soft tightening financial conditions result in an average spike in volatility that is 50% larger than when it is stable.
This is worth monitoring as the CFNAI is comfortably below 0 and credit spreads are no longer falling. Instead, high yield spreads have risen by roughly 25 basis points (0.25% points) since early March. To the extent spreads continue to back up in an environment of sluggish growth, volatility is likely to spike higher, faster. The lesson being: Without growth, financial conditions are the key to a low volatility world.