Does High Volatility Mean The Bond Vigilantes Have Returned?

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Ben Bernanke's testimony in front of Congress during the 3rd week of May might have created a sea change in sentiment where the easy money from trading the equity markets for 2013 has come to a close. No one except for Mr. Bernanke really knows the extent of the message he wanted to relay to investors, but what did come out of that testimony was the return of volatility along with a possible return of the so-called bond vigilantes.

Investors can look no further than the Nikkei 225 (NYSEARCA:NKY) to see a market that has experienced significant volatility. Implied volatility on the Wisdom Tree hedge Nikkei ETF (NYSEARCA:DXJ) has soared, moving above 37% during the last week in May. This 40% climb in implied volatility over the course of May is the largest percentage climb seen in 2013. Historic volatility - defined as how much an instrument actually moved over a 30-day period -- on the ETF climbed to 32%, before declining toward its 20-day moving average near 25%.

One of the more interesting changes to implied volatility has been the recent climb seen in the 10-year note (NYSEARCA:TLT). Implied volatility on the 10-year note was in a comfortable range between 11% and 14% between early November of 2012, when the ECB calmed markets with the creation of its tactical lending facilities, and mid-May. The recent breakout from the 7-month range coincides with a climb in 10-year yields above 2%, and should be a concern to investors.

If the goal of the Federal Reserve is to stimulate the US economy by keeping long term rates depressed, the change in yields and implied volatility has to be a concern to the open market committee. Implied volatility of 15% on TLT means that market participants believe that the price of the ETF can move up or down 15% from its current level. Volatility in the 10-year note has spilled over into the currency and equity markets and can easily destabilize the capital markets.

This rise in bond yields may be an example of what the Fed has meant by tapering off of quantitative easing. Looking at the weekly and monthly changes to Fed credit, we can see that in May the Fed did indeed back off the rate at which it was buying securities and creating new credit. But that said, it only did so back to a level equal to the advertised rate of QE. If we look at a monthly chart of the 30 year U.S. treasury yield, we can clearly see the need for $100+ billion per month in asset purchases by the Fed, if its goal is to hold the long-end of the yield curve down.

Note the ferocity with which yields rose in May. This was the worst monthly close on the 30 year U.S. bond in nearly 2 years, since August 2011. With the Japanese Yen's (NYSEARCA:FXY) depreciation pretty much over, thanks to the interventions by the Bank of Japan intended to dry up some of the leverage present in the FX markets, the major impetus for the dollar's strength has been arrested as well.

This is where all of the tapering talk from the Fed is coming from. It has been able to get away with a massive expansion of its balance sheet by the simultaneous depreciation of the Yen which has created artificial demand for the dollars the Fed printed in buying up all of these mortgage-backed securities and treasury instruments.

If the Japanese are not going to continue devaluing the Yen to push traders into dollars (NYSEARCA:UUP) and then, by extension, equities, then the money from all of this QE will finally be felt in the form of inflation. There are fewer and fewer places available as dollar sinks in today's markets than in the past.

The bond vigilantes know this, so the question is have they returned to call the Fed's bluff on ending QE by pushing rates up very quickly towards a yield that they know the Fed is uncomfortable with?

If so, then the Fed is in a bind. If it pulls back on QE, it will cause a flush of the equity rally. The S&P 500 (NYSEARCA:SPY) will correct from here. And the important part is that bond will fall with them. What is propping up the bond market is QE at this point and maintaining current rates requires a minimum amount of QE monthly. Without that support and the subsequent flow into equities then it makes sense to expect weakness in both should that occur.

If it doesn't pull back on QE without the Yen acting as a massive dollar sink, then it risks rising inflation and real yields dropping again which would send gold (NYSEARCA:GLD) and other inflation hedges screaming higher. Now that the dollar rally is likely to pause, the hedge funds should begin reversing their short gold / long dollar trade as well allowing the securitized price of gold to catch up to the physical demand.

We still feel that all talk of QE ending is nothing more than talk. Falling stock and bond prices is simply not in the Fed's playbook. It would mean flushing the very banks it has worked so hard to save over the past 5 years.

This week's close on the S&P 500 did not confirm a two-bar reversal on the weekly chart (below) as it did not violate the May 13th low. So, heading into June, there are strong probabilities of a continuation of the current short-term trends but no strong confirmations.

According to the minutes of the last FOMC meeting, many of the FOMC voting members continue to believe that quantitative easing will remain for the foreseeable future, which flies in the face of increasing bond market volatility. If the bond vigilantes have indeed woken from their QE-induced slumber and are ready to drive market sentiment, stock and currency traders should keep one eye on yields and both on volatility because the bond vigilantes certainly are.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.