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Volatility Divergence Between Bonds and Equities
Today we wanted to talk about volatility, and specifically the volatility divergence between bonds and equities. So on your screen we have the MOVE index, which is considered to be the bond VIX. And we plot that against the VIX, which is obviously the volatility gauge for equities. And there’s a sharp divergence. You can see that the bond VIX has now moved up to levels last seen in March of 2020, which was a fairly catastrophic year or catastrophic episode, I should say. And equity markets, you know, the volatility the VIX index is well off of 2022 highs, and certainly nowhere near that of March 2020 too.
And this is something we actually touched on in our note this morning, our subscriber note. One is if you just look at the prices of equity puts in general, we have here is our 25 delta 30 days risk reversal and all this is doing is looking at the price of call options relative to the price of put options and it uses the 30 day rolling view so we’re always kind of measuring the same option in time and we can see is that we just came off of two days ago a period of relative calm in the markets the s&p was pushing back to 4600. And the call to put ratio this sort of risk reversal measure was saying look, the market doesn’t have any demand for puts right now there’s not much concern now we’ve dropped 100 points, since that time in the s&p in this risk reversal metric has just slipped down to roughly eight as you can see here.
Now in the depths of sort of the Ukraine situation in February we will touch down to this 14 area as you can see the real lows back to the March of 2020 sort of saga or down around 16. So this is real fear down in this area. And you can see that in this case, even though it dropped two or 3%. There’s just not that real bid for puts in equity in the equity market.
And you can see just below this risk reversal metric. We touched on this really interesting tidbit that IV technicals put out on Twitter and he mentioned that the 30 day straddle for the TLT that’s the US long bond government bond ETF is now over that of spiders. So that syncs with this idea that there is a big divergence between the volatility in credit markets and the volatility in equities. So let’s take another look at another chart that sort of displays this. So here what we’ve done is we actually showed we plotted the history of the 30 day implied volatility, that’s the 30 day, implied options volatility of TLT in blue, versus that of spiders in orange, and what you can see here as mentioned in that note, is at this time, the TLT, which is the blue line, again, is above that of spiders.
Now, typically there’s a pretty good correlation between volatility in these two asset classes. You can see here there’s a big spike in August of 2015. Between the two of them, there’s a big spike obviously March of 2020, and then some of these other episodes throughout time. Now, what often happens in sell offs and equity market sell offs, when there’s high risk is traders will sell equities, and they will look for the security of the risk free government bonds, right. And so a lot of times this volatility that you’re seeing corresponds with people flooding into the TLT or long bonds because they’re looking for protection. And so that is certainly what a lot of the volatility this blue line higher in March of 2020 was, as well as some of these other episodes. And then you’ll note there’s a couple of other divergences here and typically what that is, is after about or around a fear, equity volatility will drop really hard, and then that will leave the long bond volatility just a little bit higher. That’s that’s kind of what a lot of these divergences are.
But this here’s something different. This is a build in credit market TLT volatility. And it corresponds with a build, a small build, obviously, in equity market volatility, but over the last few weeks, we’ve gotten equity market volatility subsiding. But the TLT long bond, which is obviously the most sensitive government bond to interest rates, you’re seeing that volatility continue to go higher.
So again, this syncs with the idea of the move index moving up or shifting higher, and the VIX not responding in the same way. So we’ll just show this, the price of these two instruments relative to each other to help display exactly what we’re talking about. As you can see what kind of big sell off in the equity market, just flag a few of these.
What you see obviously is a corresponding jump in the price of TLT. This is again a flight to safety if you think about the idea of the 60/40 portfolio right, people hold or own bonds as a way to offset the risk in their equity portfolio. And in this case, when things get really scary in the equity market, you look for a little bit more of a bond allocation and then after the fear subsides once off typically happens the Fed will come out and say hey, we got your back the Fed put us in place.
People sell those bonds and they buy back equities. And so you see this and this corresponds to that spike in volatility with TLT often is that it’s almost like a spike because people are driving in to buy there’s so much demand to get in because of the fear trade and then the volatility will come back down as the fear subsides and traders go back into equity.
So you can see that was generally what the correlation is. However, what is happening here is a little bit different. In this case, we have equity markets selling off in a much bigger relative sell off in TLT in the government bonds. And so the correlation of these two is flipping a little bit there was some bouts of this situation wherein people were feeling like during the COVID crash, that bonds were not acting as an effective hedge for equity portfolios. And there was a lot of talk about the fact that look, if you really wanted to hedge this volatility, you’re going to have to buy an actual actual volatility right, you’re gonna have to buy likely something like VIX futures, own put options in equities or something of the sort.
So this is a this is a unique divergence here the fact that equities are coming down and long bonds in particular selling off hard now you’re getting the 10 year selling down, etc. And there’s not a good timeframe. For when this is going to end, right. That doesn’t seem to be clarity on how many rate changes we’re expecting. What’s inflation going to do. You got midterms coming up, and there’s just not a clear path to resolve this volatility.
And so what’s really the big deal about that? Well, one of the most popular strategies for funds is this idea of risk parity or vol targeting. So if you think about Bridgewater, biggest hedge fund in the world, there’s a lot of other very large funds that they model strategies or they run strategies that are based on this general model of targeting volatility.
So how much volatility exists in bonds and in various currencies, or commodities and equities, and they target a certain amount of volatility based on historical factors. I’m making some generalizations here just to prove the point but on your screen is the risk parity ETF.
Now this risk parity ETF could use some different strategies obviously, like Bridgewater, or something of that sort, but the point is going to be the same. You can see that this strategy started, or this ETF rather launched just before the COVID crash. And in general, it’s performed with equities, even outperforming equities a little bit over the last two years.
And what you can see is this divergence, and this is almost exactly like the inverse of the move in vix divergence, right? In this case here though, we have the risk parity fund dropping or strategy dropping with equities kind of popping over the last few weeks. And this is a result of that bond market volatility when that bond market volatility is too high, they have to get out of bonds to reduce their exposure to that asset class that causes some losses and some deleveraging etc. So when a lot of strategies are tied to the fact or based on the fact that credit market and bond volatility should be lower or is historically lower than what we’re seeing now.
That causes issues with a lot of these strategies. And you can see, again, this is a clear divergence, something that we arguably haven’t seen over the past and that again, is anecdotal, but this this really explains sort of what sort of the risk is in terms of flows coming into and out of the market. We would also note that if you just look at a divergence in equities themselves, you get another part of the picture. In this case, the s&p is well diversified, right.
Do you have exposure to some commodities? Defensive cyclicals all sorts of different stocks in the s&p 500? That could offer you some protection in this changing macro environment? Whereas in the Q’s, you have a much more interest rate sensitive set of stocks and that outperformance or that divergence is really seen pretty clearly in here. So there’s some argument that look the reason that the VIX isn’t quite as high is simply the fact that the s&p is receiving money and there’s some sector rotation but on net, that is keeping the s&p up fairly well. But in this case, you have a situation where tech is clearly underperforming.
So that is again, part of the fact that the interest rates are shooting higher. Now obviously the biggest components of the s&p 500 are all tech stocks. And so when you have that they’re all core components of the Q’s. Eventually you’re going to get high correlation if if there is a strong enough sell off.
So let’s talk about what we think that means for equities. Well, this point here is where the Fed Brainard came out and said that they may be more aggressive with the rate hikes and that has caused a major decline in equities. We lost, you know about a little over 100 points 100 handles right in the s&p, and that put us back into this sort of, very neutral to negative gamma point. We’re using 4500 as our game of flip level.
There’s a big bunch of open interest at this level. And it’s below this vol trigger line, wherein we see high volatility in the market. And that is led by an increase in implied volatility, and a pickup in negative gamma. We have a bunch of other videos that discusses these dynamics. But the point here is that we have fairly muted demand for put options.
We have a vix that just does not seem to want to move higher in correlation with that larger bond volatility. And we think that the equity market is really going to need to kind of catch up to that. Because again, if we go back to this first chart we’re looking at and you say, look, the credit market is much larger than the equity market. It’s screaming about volatility and uncertainty.
And there can be certain flows that are out going out of the bond market obviously and into equities, but the fact that this continues to shift higher, with a low demand of puts with volatility, not really spiking thing, this is a flag of divergence that isn’t making a lot of sense. And these two, we believe, need to sort of shift together.
And we think that the way that this is going to rectify itself is likely a sell off or drawdown in equities. And then eventually we’ll get some sort of resolution on the interest rate side where people can start to forecast and better understand, look, here’s our expectations is going to be 3456 hikes, whatever it may be, but there’s clarity here and we can start to model and forecast the future right because right now you just can’t really do that given not just the Fed but also the the inflation the geopolitical situation.
So we’ll continue to be writing about this in our daily subscriber notes.
