Through the Looking Glass: Scenarios on Volatility, Correlations and Bonds

Volatilities and correlations between assets may vary due to changing fundamental or economic conditions, thus making past data obsolete or irrelevant.

This is most apparent in “extreme event” scenarios that involve natural disasters. What if an earthquake with a severe magnitude damaged electricity systems and power gridlines, which in turn caused fire in addition to the earthquake disaster? Imagine seismic waves in the immediate aftermath causing disruption of water and sea levels, hence creating tsunami waves on top of everything else. Add a final insult to the injury in the form of riots and looting that result from the dissolution of a Hobbesian-style “social contract society”.

Hollywood is generally the kind of place where such events trigger one another to create a sensational film. But we do consider such events as being independent from one another whereas the very occurrence of one can actually lead to the occurrence of another. This results in increased correlations between events in case of worst-case scenarios. Do you think I’m exaggerating?

Anyone who has witnessed a market crash will attest that the psychology of the moment resembles something like the story above. It is as if the market is reflecting such forward-looking pessimism, when expectations discount certain worst-case scenarios that may or may not occur, as if foreshowing an era reminiscent of the Great Depression.

But many have seen a bull market reflecting the opposite state of affairs, when one good thing causes the other. An economy that invests in proper infrastructure ensures better allocation of its resources along with better education of its people. Companies greatly benefit from such state of affairs, thus triggering an economic boom. America has benefited from such conditions for the last two centuries, and it’s had an incredible bull market to reflect this state of affairs.

Today, the U.S. Treasury Bonds enjoy the status of being one the safest (if not the safest) instruments in the financial markets, partly due to America’s very successful market history. They enjoy the “safe haven” status during the times of market crash, but they also benefit somewhat from a bull market. This is why 30-year bond price returns show the least correlation with stock market returns. A bull market may drive up the Treasury bond prices while pushing yields down, due to more optimism and perhaps some “wealth effect”. A bear market, on the other hand, may also benefit the Treasury bond prices due to liquidity flows to safe havens, resulting in some type of a “substitution effect”.

However, because the perceived risk of U.S. Treasury bonds is so low (default risk is zero), these instruments don’t have high returns, especially given low inflation levels of today when compared with the high inflationary environment of 1980s. High-yield (junk) bonds, on the other hand, have higher returns in order to compensate the investor for the risk premium. Their returns also show more positive correlation with stock market returns. The greater probability of default makes high-yield instruments show more stock-like characteristics as an asset class than bond-like characteristics.

The price behavior of 10-year bonds, on the other hand, has surprised most economists when the long-term rates refused to rise during the Fed tightening of short-term rates from June 2004 to December 2005, causing Alan Greenspan to label the development as a “conundrum”. Ben Bernanke explained the phenomenon resulted from a “global savings glut”, whereby cash piles from trade surplus producing countries, as well as AS oil exporters, ended up being invested in U.S. Treasury Bonds, the surge in demand keeping the yield at historically low levels.

A reversal of capital flows resulting from the current “global savings glut” could reverse the current picture. The dollar would lose ground along with a surge in interest rates, while driving down the value of Treasury Bonds. Bond investors would learn that investing in Treasury Bonds indeed came with some risks despite the zero probability of default.

While this article does not forebode a severe bond market crisis resulting from a sudden “unwinding” of a “global savings glut”, it is meant to remind investors that being invested in bonds also means being exposed to market risk.

It is also meant to remind those who wish to refrain from risk-taking activities that the biggest risk of all may be not taking any.