Chart Of The Week: Yield Curve Points To Higher Volatility

by: Topdown Charts


The U.S. Treasury 10-2 year bond yield curve has been flattening at an increasingly rapid pace.

This is to be expected at this stage of the cycle, and we expect the yield curve to fully invert within the next 6-12 months.

The chart of the week suggests that this will mean generally higher stock market volatility over the next couple of years.

The chart of the week is the US yield curve vs. the CBOE volatility index. There has been a lot of interest in the yield curve, and for good reason (as we will discuss). The US Treasuries yield curve (10-year vs. two-year bond yield) has flattened considerably over the past year, and this is exactly what you typically see at this stage of the business cycle.

The chart comes from a report on the yield curve outlook and the implications for risk assets. Basically, our analysis shows that this flattening of the yield curve will not slow down any time soon, and if anything, we expect the yield curve to fully invert within the next 6-12 months.

US treasuries yield curve vs the CBOE VIX volatility index

First, a quick note on the detail of the chart. The chart shows the CBOE VIX (implied volatility index) against the 10/2-year Treasury bond yield curve - which has been inverted and shifted forward 30 months (i.e., the yield curve indicator has about a 2.5-year lead on the level/direction of the VIX).

It's important to examine the economic logic behind correlations like this, because it's easy to stumble upon spurious correlations. But the economic logic behind this chart is sound: Basically, as the business cycle matures, the yield curve flattens. A key driver of this flattening is tightening monetary policy (rate hikes drive flattening by pushing up two-year bond yields), which often leads to the end of a business cycle and thus a spike in volatility as the stock market cycle also comes to an end.

At the long end of the curve, bond market participants are constantly discounting information and expectations about future growth and inflation. As you get closer to the end of the business cycle, naturally this would mean that 10-year bond yields would start to top out or even fall as bond traders anticipated softer data ahead, thereby driving flattening by keeping 10-year bond yields constant if not pushing them lower.

So on the back of this chart, it's entirely reasonable to expect volatility to be generally higher and to trend upward over the next couple of years.

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