There's a Big Disagreement Between Bond and Stock Traders About Interest Rates

Bonds and stocks are signalling two very different things

CBOE GOLD

Here are some traders working in the Vix pit on the floor of the CBOE.

Photographer: Tim Boyle/Bloomberg

Bond traders have a long-running reputation for being more pessimistic than their stock market counterparts, and it looks as if that disagreement is becoming more pronounced.

The ratio of rates volatility to equity volatility is at a post-financial crisis high, according to a note from Torsten Sløk, Deutsche Bank's chief international economist. 

The difference between the MOVE Index, which measures swings in U.S. Treasuries based on options prices, and the Chicago Board Options Exchange Volatility Index, a gauge of future turbulence in U.S. equities, reached its highest level since 2008.

In other words, the U.S. government bond market have been pretty jumpy while stocks (as measured by the VIX) have been kind of meh.

 

This has been the case for much of the year, and Sløk says there are two key reasons that rates volatility has moved up while equity volatility hasn't. For a start, uncertainty over when the Federal Reserve might raise interest rates is having an obvious impact on the Treasury market. Secondly, that impact is becoming more pronounced thanks to a lack of liquidity in the U.S. bond market.

Sløk goes on to argue that equity investors might want to worry a bit more about the Fed and its monetary policy actions.

Although many of the people he speaks with believe stocks will do well when rates finally do rise—since they'll presumably be rising as the U.S. economy improves—he says that might not be the case.

The risk to equities is not problems from a bottom-up perspective but rather what the normalization in fixed income will mean for equities. The key question investors need to think about is the following: What comes after the seven-year carry trade we have had in fixed income and what is the impact on equities of the normalization that is coming in rates and spread product? If we have a violent adjustment in rates and rates vol and credit spreads then it is difficult to see how equities can perform well in that environment. The bottom line is that the risk to equities is not only the risk of a recession but also the risk that the normalization in fixed income spills over to equity markets.

His conclusion is that either rates markets are right in the assumption that the Fed's first rate increase will be volatile, or equity markets are right that it's a non-event.

Whatever the case, Sløk says, the ratio of the MOVE to VIX will likely to be moving closer to its long-term average pretty soon.

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