The U.S. bond market, as the aggregation of all knowledge regarding economic growth and inflation expectations, has a knack of predicting future market returns in what often appears to me as an exercise in pure sorcery. Right now, Treasuries are predicting a difficult, volatile outlook for investors.
Tobias Levkovich, Citi's chief U.S. equity strategist (and former Montreal resident), published a chart Friday showing the U.S. yield curve's uncanny ability to predict the path of the CBOE volatility index (VIX), a widely followed measure of market risk.
In market parlance, "volatility" is a term often (but not always) used as a euphemism for "very painful sell-offs." The VIX, which uses futures prices to predict the scale of short-term equity market moves, rises most dramatically when the S&P 500 slides. In early 2016, for example, the VIX hit 27, almost double the lows of November, 2015. During that same period, the S&P 500 fell almost 12 per cent (not shown on chart).
Mr. Levkovich's chart is reproduced here. It compares the steepness of the U.S. yield curve – calculated by subtracting the three-month Treasury yield from the 10-year Treasury yield – with the VIX index. Please note that yield curve steepness is plotted inversely to better show the trend – a rising line indicates a flattening yield curve and a falling line shows a steeper curve.
The grey line is lagged two years (Monday's VIX reading of 13.1 is shown on the X-axis on April 25, 2014) to show that the shape of the yield curve predicts the rough value of the VIX 24 months later.
The chart illustrates that the relationship between the yield curve and the VIX outlook works best at extremes. The sharp flattening of the yield curve from 1994 to 1995 (reminder, the data are plotted inversely) successfully predicted the spike in the VIX in 1997. (With the two-year lag for the VIX, note that this spike is plotted in 1995.) More importantly, the steadily flattening yield curve from early 2004 to 2006 provided ample warning of the massive spike in the VIX in 2008 during the financial crisis.
The future is the primary concern of investors, so the end of the chart is the most important. The yield curve has been in a flattening trend since the end of 2013, when the difference between the three-month T-bill and the 10-year bond hit 294 basis points (2.94 per cent). This trend created the rising orange line at the end of the chart.
History suggests that the VIX index should climb toward 30 – similar to the level during the equity market sell-off in January – in the next 24 months, following the path previously laid out by the yield curve.
Mr. Levkovich's conclusion is succinct, "expect volatility to stick around."
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