Why a steadier bond market supports stocks

Russ discusses how calmer bond markets have benefited equities.

Equities continue to grinder higher driven by stellar earnings. And while multiples have been mostly flat year-to-date, valuations remain supported by low and stable rates. Put differently, the steady rally in equities is linked to a quieter bond market.

Back in May I last discussed the significance of bond market volatility for equity markets. At the time there was considerable uncertainty surrounding both inflation and the Fed’s new reaction function. As a result, after years of trading with a negative correlation to stocks, bonds and equities started co-moving to a degree not seen in two decades. In addition, bond market volatility was quickly leaking into stock markets.

More recently bond market volatility has ebbed, in the process benefiting equity markets. Volatility in the U.S. Treasury market, as measured by the MOVE Index, recently traded close to the June lows. Rate volatility is now down roughly 20% from the July peak and 25% from the February top (see Chart 1).

Bond Volatility – ML MOVE Index 
Merrill Lynch MOVE Index showing volatility in US Treasury market U.S. Treasury volatility

Not coincidently, equity market volatility has also moderated. Implied equity volatility, measured by the VIX Index, has been lingering in the mid-to-high teens, below the long-term average. The “volatility-of-volatility” has also plunged, down roughly 30% from the summer peak.

The recent moderation is consistent with the post-pandemic normalization. Based on weekly data, last year implied volatility averaged slightly under 30. While the 2020 average is obviously skewed by last spring’s panic, even during the back half of 2020 the VIX averaged around 25. Year-to-date the VIX has averaged slightly under 20, in-line with the long-term norm.

The drop in implied volatility, which reflects investor willingness to pay for index options, has followed a similar decline in realized volatility, i.e. the annualized standard deviation of stock returns. One-year realized vol on the S&P 500 is 15%; while three-month volatility is around 10%.</p.

With realized volatility confirming the drop in implied vol, one big question is whether bond markets will play along? This matters as the direction of bond market volatility continues to be a key driver of equity market volatility, a dynamic confirmed by the data.

Year-to-date the beta of equity volatility to bond volatility has been roughly 0.95; the MOVE Index has also explained approximately 30% of the variation in the VIX. This suggests that both the sensitivity and significance of equity markets to bond market volatility remains elevated. In other words, to a greater extent than normal stocks are taking cues from bonds.

Implications for portfolios

More muted bond volatility has several implications for equity positioning: Most importantly, low and steady rates provide a supportive backdrop for stocks. The current regime also suggests favoring non-financial cyclical expressions over banks. As I’ve discussed, the bank trade is somewhat hostage to bond markets. If rates stay quiet there are arguably better cyclicals expressions in consumer discretionary, materials and industrials. Finally, lower volatility, i.e. cheaper options makes it economical to own more equity exposure in option form.