Low Global Interest Rates Are Not Consistent With A Low VIX

Includes: DIA, QQQ, SPY, VXX
by: Vahan Janjigian, CFA

One of the biggest mysteries in investing today is why are interest rates so low? The obvious answer is that low rates in the U.S. are a result of Federal Reserve policy that was formulated in response to the extraordinary financial crisis that began in late 2007. The Fed provides its own explanation here. But interest rates are low all over the world – even in the southern European countries that were close to financial disaster not too long ago. For example, the 10-year yield on government bonds is Spain is just 40 basis points higher than it is in the U.S. That’s a country that has a 27% unemployment rate. Youth unemployment is well over 50%.

An even more mysterious question is why are investors willing to buy bonds – especially government bonds – when interest rates are this low? After all, central banks are not the only buyers in the market. There are plenty of stocks that have earnings yields that are well above bond yields. There are even a large number of stocks that offer dividend yields above the 10-year Treasury yield. So why would any investors, other than central banks, buy Treasuries at all?

The answer must be related to risk. Stocks, of course, are riskier investments than are bonds. As shown by Aswath Damodaran, since 1928, the geometric average return on the S&P 500 (including dividends) is about 9.6%. The corresponding return on 10-year Treasuries is 4.9%. However, stocks exhibit greater volatility. Despite that greater volatility, if we assume that stocks and bonds will behave in the future in a manner that is at least somewhat similar to how they have behaved in the past, why would anyone with a long-term investment horizon buy bonds today when interest rates are this low?

Take a look at the graph below. It shows that the 10-Year U.S. Treasury, which is currently yielding only about 2.4%, has been on a downward drift since the 1980s.

The following graph shows the yield on an inflation-indexed basis. It is close to zero percent!

The fact that investors are willing to accept a near zero yield on Treasuries tells us something about the attitude toward risk in the market today. You have to be extremely risk-averse to lock yourself in for the long term at such low returns. Yet at the same time, the level of fear in the stock market as measured by the CBOE Volatility Index (a.k.a. VIX) is also near an all-time low. This seems extremely inconsistent. On the one hand, investors are willing to accept zero returns on Treasuries because they want to avoid risk. On the other hand, the VIX is indicating that there is very little fear in the stock market.

Something has got to give. Despite the Fed’s tapering, interest rates have continued their downward drift. Yet almost all investors agree that interest rates have to rise eventually; that is, unless the economy is headed toward another slowdown or possibly even another recession. Indeed, today’s second estimate for first quarter GDP suggests that another recession is a real possibility. Many economists are chalking up the worse-than-expected 1.0% contraction to bad weather. They are betting on a big rebound in the current (second) quarter. But if the economy were really on the mend, interest rates should rise as the demand for loans increases. Furthermore, if the economy were truly getting better, investors would sell bonds and rotate into riskier assets. None of this appears to be happening. Alternatively, if the economy is not on the mend, stocks should sell off.

The fact that so many investors other than central banks appear willing to buy bonds at such low yields suggests that the market’s view is that global economies are still very troubled. The VIX is low, but it may be near a bottom. This seems to suggest that the likelihood of some kind of sell off in stocks is rising.