Over the last few years investors have remained within the boundaries of a so-called new normal where periods of risk-on follow periods of risk-off with no genuine correlation breaks. The possibility of a Fed early exit, the sustainability of U.S. and emerging growth, and the end of the Greek systematic risk could pave the way to a new new normal that brings us back to pre-2007 days.
The SP 500 is back to 1400 but the gap between the SP 500 and the 10-year UST yield is still wide. It would have been irrelevant to take the distance between both series back in 2007 to assess the upward potential of UST yields. In addition, a macro-data-based model can easily track the changes in UST (there is 15-20 bps shortfall mentioned suggested by the recent upward move of the SP 500) but fails to even get close to the current level of rates.
The chart highlights the gap between a traditional yield model (adjusted R2 of 0.8) based on the VIX, the U.S. economic momentum, a dummy for the QE2 and Operation Twist, and the current level of Fed Funds. The current level of 10-year UST is at least 100 bps away from fair value.
We don't need a model to see that. What we need is an assessment of the potential drivers which failed to pull the yields upward. There are two potential candidates:
- The Fed: The publication of forecasts for Fed Fund rates does not pre-commit the Fed. Since 2010, steepening of the Fed Funds curve has come along with a steeper yield curve. The 1-year future calendar spread (FF13-FF1) still has some room to improve if the market gets the macro message right. A wider T-note/Bund spread could probably help the EUR/USD recover its traditional relationship with yield spreads (chart): a combination of higher yields, a stronger dollar (and EUR/USD down to 1.25) and higher equity prices would not be surprising in such a scenario.
2. The equity market has also been an enigma. According to our Equity desk, the reading of the VIX today should be different from 2007. We cautiously stress that the VIX term structure, albeit directional (increasing when VIX is declining), remains at a high level due to the "stickiness" of the far-end of the curve. This does not imply trouble ahead, but highlights that the VIX derivatives market has evolved and functions differently. Could it also reflect a willingness to play the rally through options rather than outright purchases?
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Even though Skew (or fat tail risk) may not have a straightforward relationship with the level of VIX (since the implied volatility of options can register parallel moves over the option moneyness spectrum) the recent disconnect suggest that investors are still concerned by an outlier.
Volumes are very telling: as can be seen below, they stand at their lowest level since 1999.
It may look like the market is cursed, or it may reflect that some traditional long-only investors are still out of the market. Given the upward potential for stocks (forward earning based PE, 25% upward potential for indices while the peak of profit-to-GDP has been reached), their return to the market would be welcome. The only question that remains in the short run is: will investors benefit from a limited increase in yields to extend maturities and search for yields, or will they disregard the new normal and come back to the equity market?