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Liquidity and Volatility

|Includes: SPDR S&P 500 Trust ETF (SPY), VXX, VXZ

Equity volatility might seem to have little to do with the level or shape of interest rates, but after a bit of exploration we might be able to draw some solid conclusions.  In a recent post I looked at the current record steepness of the yield curve and suggested that it might be a prelude to rising nominal values as it was in 2003.  Now it is time to take it a step further and see what it means for equity volatility.  The argument is that a steep yield curve means that longer term rates are suggesting higher growth and/or inflation in future years.  If this does not make immediate sense to you, then please read a very popular post that outlines the components of interest rates.  The other piece of this argument is that when the yield curve is steep, this usually means that short-term interest rates are being kept artificially low by the federal reserve.  We often call this “easy money” because the cost of borrowing is low, but another way to think about it is that you earn zero or very low yields for holding cash and short-term investments.  This usually forces institutions and individuals to chase risk, meaning that they push credit spreads tighter and equity markets higher as they search for yield and total return performance.  With this as the underlying argument, does it hold any water?

The correlation has been consistent

Every type of financial analysis must be questioned and can only serve as one piece of an investment puzzle, but in this case and under this premise it would seem that the steepness of the yield curve would suggest much lower volatility levels in the future.  The aspect that cannot be accounted for in this rather short history is the scale of the market dislocation during the credit crisis.  We can only look back to the great depression to find an analogous period and option markets were hardly developed. 

Disclosure: Short SPY Put Options