Bond Volatility at Odds With Recent Stock Rally

The volatility in bond yields in the last year or so is a sign of uncertainty regarding inflation, the Federal Reserve (Fed) and the economic cycle. How is that volatility measured? Just as there’s an established measure of stock market volatility, there’s also one for bonds—the MOVE Index.

How Does the MOVE Index Measure Bond Market Volatility?

The VIX Index is commonly referred to as the stock market’s “fear gauge,” and just like the VIX, the MOVE is derived from changes in option prices. Indeed, the “OVE” in MOVE stands for “option volatility estimate” and focuses on Treasury bond options.

The index currently stands at about 120.* It’s been as high as 180 recently. The only other times we’ve had Treasury yield volatility hitting similar levels for a sustained period were in September 2001 and following the collapse of Lehman Brothers in September 2008. (Those were also the last two times we had sustained recessions prior to the COVID-19 pandemic.) In contrast, the VIX has been falling and stocks have been rising—more or less consistently for the last six months or so.

Even during the depths of the pandemic, we only saw the MOVE temporarily hit today’s levels for one day, on March 9, 2020. That was it. So we think you can add this MOVE indicator to the laundry list of indicators predicting a recession.

How Do You Explain the Rebound in Stocks?

With all the talk of recession, a stock rally might seem contradictory. This conundrum is being termed “immaculate disinflation.” That is, equity investors appear to be saying that somehow inflation goes away on its own without a full-blown recession.

Against that, federal funds futures are pricing in three rate cuts this year. That and the level of the MOVE Index are indicating that the bond market thinks there’s a severe economic downturn ahead.

We’re not sure how to reconcile those conflicting outlooks, but they can’t both be right.

What About Current Stock Valuations? What’s the “Rule of 20”?

The so-called “rule of 20” is an equity valuation metric that combines the current price-to-earnings (P/E) ratio of the market with the rate of inflation. It dictates that anything above 20 is overvalued, while anything under 20 indicates undervaluation. Therefore, current levels would indicate caution as the market appears overvalued by this rule, with the market P/E hovering around 18 times and inflation at 5-6%.

This implies that either inflation has to come back down to 2% in order for the market to be fairly valued and/or the P/E needs to drop from 18 down to about 14. In other words, according to the rule of 20, stock prices would need to fall by about 25% from current levels to be fairly valued or earnings would have to rise by over 30% from where they are to justify today’s prices.

As with any other rule of thumb (and there are many), I’m sure this one has its origins based on some level of historical accuracy. And in fairness, this one is more robust than most because it takes into account current prices, forward-looking corporate earnings, and, indirectly, interest rates (as implied by inflation).

Does it work? I don’t think so, unless you need an indicator that only works 10 years out. In any event, making consequential investment decisions based on the rule of 20 or any other general thumb is not wise.

What’s the Outlook for Bonds, Given the Current Environment?

Our global fixed-income team has been clearly and consistently articulating their outlook and positioning for 2023. Here’s a brief summary of their expectations for the rest of the year:

• Slowing inflation

• Hard landing/recession

• End of Fed rate hiking cycle

• Lower bond yields

This outlook has led to the “long duration, short credit” general theme you’ll find across most of our fixed-income strategies today. I say “most” because this positioning is expressed to varying degrees consistent with each strategy’s risk/reward profile and guidelines.

“Long duration” means adding longer-term bonds, which stand to benefit more from falling bond yields. Bond prices and yields move in opposite directions. Duration measures a bond’s price sensitivity to yield changes. The longer the duration, the greater the price sensitivity. So, ideally, you want longer duration when bond yields are falling, and shorter duration when yields are rising.

“Short credit” refers to exposure to credit risk. Credit risk is an assessment of the likelihood of default; that is, that a bond’s issuer will fail to make all interest and principal payments on time. Higher-rated bonds carry less default risk, while lower-rated bonds have a greater possibility of default. So, when we say we are “short credit,” that means we are reducing credit risk by favoring higher- over lower-rated bonds.