Macro Volatility And Asset Prices

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Includes: VXX
by: Evariste Lefeuvre

Summary

The volatility of asset prices is strongly linked to the macroeconomic backdrop.

I highlight several relationships between pure macro variables and the implied volatility of stocks and U.S. Treasury bonds.

The message is clear: the macro drivers of volatility points toward an increase in bond yield volatility.

The message for the VIX is less straightforward.

It is now common wisdom that volatility will rise in 2015. So far yet, in spite of the recent risk-off related increases in VIX and CVIX, overall volatility has failed to structurally shift to a higher level.

The relationship between VIX and the macro backdrop is not always straightforward. The chart below shows for instance that the VIX is often, but not always linked to the rolling standard deviation of the ISM Manufacturing (an indicator of macroeconomic volatility)

For instance, the VIX shun the weather related spike in U.S. macro volatility earlier this year. The current reading of ISM volatility is not inconsistent with a low level of VIX.

Forecasting asset returns volatility from economic forecasts is almost impossible since, by construction, economic forecasts are smoothed (they are based on underlying assumptions that are closer to macro momentum than external shocks). Using the consensus makes things worse since it is based on median views.

For that reason, a good proxy of macro volatility is the dispersion of 1-year ahead forecasts. As can be seen below, the currently low level of the VIX is well explained by the lack of dispersion among forecasters. It could be that market complacency goes hand in hand with economists' complacency. It could also mean that temporary macro shocks (such as last year's cold weather) should have no impact on asset price volatility as long as they don't impact the underlying economic momentum.

The macro drivers of stock market returns are not the only ones to be driven by the macro landscape. The MOVE, which is an index of U.S. Treasury volatility across tenors is highly dependent on:

1. Excess liquidity. Excess liquidity is measured as the difference between central banks' balance sheet growth and nominal GDP growth. the chart below shows that it has an impact on the MOVE: a strong growth in excess liquidity comes along with a fall in bond yields volatility.

As the Fed will stop buying bonds and the ECB will fail to increase significantly its balance sheet, excess liquidity will be lower. Not that there will be a destruction of liquidity, since the Fed won't reduce the size of its balance sheet, but the growth differential between global monetary base and global nominal GDP will dwindle, as the arrow suggests. This is clearly an upward signal for the Move (lower growth of excess liquidity entails a upward change for the MOVE).

2. The distance to the Fed tightening. As can be seen below, the shorter the distance to the market-implied expected first hike date, the higher the move (against its rolling past average). The shrinking distance between today and the date of the first hike should lead to a much higher level for the MOVE)

3. The dispersion of PMIs is generally a good indicator of "fair value" of the Move. Here again, the lack of synchronization of economic cycles across the globe should have led to a higher level of bond yields' volatility.

4. Lastly, the dispersion of 1-year ahead monetary expectations used to be a good driver of changes in overall bond yields volatility. The chart below shows that, up to the Great Recession, an increase in the dispersion of 1-year ahead 3-month rate forecasts (that is higher uncertainty on forthcoming monetary policy changes) would come along a higher level of yields volatility. Yet, since the implementation of QE, the relationship has totally broken down.

It would therefore be dangerous to use this chart to forecast the forthcoming trend of bond volatility. Yet, assuming that the end of the Fed's balance sheet expansion will bring markets back to a more traditional correlation/volatility regime, the recent increase in the dispersion of 3-month rates expectations would also call for a higher level of MOVE.

Bottom Line: The good news from this post is that asset price volatility has many macro drivers. Interestingly, the odds for higher bond market volatility are quite high: distance to tightening, PMI dispersion, excess liquidity growth. The message from the VIX remains unclear since the economic momentum is still solid in the US. Yet, given the co-movement in different asset classes implied volatilities, I would bet on an upward trend for volatility in the next few quarters, since the message from the macro drivers are mostly on the upside.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.