Why has Equity Index-Treasury Options Volatility Diverged?

The divergent behavior of Treasury and equity index options markets is somewhat surprising because normally these two markets move more-or-less in tandem. Were equity options traders right to have been so worried?  If so, were bond options traders wrong to have remained so calm? More broadly, after an extended period of exceptionally low volatility in both markets, are we turning the corner towards a higher volatility regime? Or, alternatively, were the 2018 spikes in equity volatility an aberration in an otherwise low-volatility period?

What is particularly striking about the seeming disconnect between equity and fixed income options is that, in large part, it was the Federal Reserve’s (Fed) monetary policy that was the cause of the equity market’s distress. Equity investors feared, among other things, that the Fed would overtighten rates, putting downward pressure on corporate profits, slowing economic growth and even risk a recession.  Bond investors appeared to be concerned about the same issues, as the yield curve briefly inverted on the 0-to-5-Year segment.  Even so, while equity option investors were sounding the alarm and bond prices rallied, bond option investors didn’t seem to get the memo.  

In some ways, the bond market’s lack of concern is even more surprising given the rapidly expanding U.S. budget deficit, which grew from 2.2% of GDP in 2016 to 4.4% in 2018 – an unprecedented growth of deficits during a period of declining unemployment. One might have thought that bond options traders would have been more concerned about the unusual combination of tighter monetary policy and expanding budget deficits. So, what kept a lid on bond volatility?

The notion that the Fed is now either on hold, or at least more data dependent, may be what’s keeping bond market volatility from rising further. Moreover, the equity market’s tumble in December 2018 was what persuaded the Fed to rethink further rate hikes.  When the Fed announced its decision to raise rates on December 19, its dot plot survey indicated that the central bank expected to hike rates twice in 2019.  By early January, Fed Chair Jerome Powell and company appeared to have backed down in the face of an equity market rout.  As such, the equity market selloff, which sent equity index options spiking to higher levels of volatility, may have been exactly what the fixed income market needed to keep a lid on volatility: stable policy rates.

What happens from here on depends upon whether equities stabilize.  If equity volatility subsides, bond options traders will be vindicated in their relaxed assessment of risk.  On the other hand, if the stock market falls out of bed again, then the bond options traders’ sanguine view of risk will likely prove to be wrong and bond volatility could follow equity index volatility to much higher levels.

As we have documented in the past, both bond and equity index option volatility appear to have a strong cyclical component related to monetary policy:

• When monetary policy is easy, volatility typically subsides.
• As volatility falls to low levels, the central bank eventually begins tightening policy rates.
• Typically, after 1-2 years of flat yield curves and tight monetary policy, volatility rises across asset classes.
• The sharp rise in volatility usually coincides with an economic downturn that obliges the central bank to ease policy. After the policy easing, the cycle begins anew.

Equity and fixed income options markets have repeated this cycle twice so far this decade (Figures 3-6), and with the equity market it can be traced back to the late 1980s.  For the employment markets, the cycle goes back even further – to at least the early 1980s.

In past cycles, it often took about a year-and-a-half of flat yield curves to provoke a sustained upward shift in equity and bond options implied volatility. Once the shift occurred, however, volatility wasn’t simply a short-term feature of the markets.  High volatility stayed around for many years (1997 to 2003, and 2007 to 2011).  A pause in Fed tightening might stave off a spike in volatility in the short term.  That said, with just 60 basis points (bps) in steepness between three-month and 30-year rates, even if the Fed stays on hold we might see a much more volatile period ahead.  What isn’t clear yet is whether that more volatile period has already begun or whether volatility will subside one last time before a major eruption sometime later this year or perhaps around 2020 or 2021.  Events may answer that question soon.

One final note: another possible explanation why equity index volatility rose much more than U.S. Treasuries could lie in a surprising source: the oil market.  When oil prices fell 75% in 2014-16, equity index volatility rose somewhat (Figure 4) while Treasury options volatility remained subdued (Figure 6).  Energy companies constitute about 10% of the value of the S&P 500® index.  As such, energy sector stocks tumbling 32% may have contributed to a drop in bank stocks as well since many financial institutions have exposure to the energy industry. Meanwhile, Treasury investors have essentially no direct exposure to the ups and downs of the energy sector and tend to think that fluctuations in oil prices have little impact upon long-term inflation expectations.

If this oil-related explanation of the divergence is true, it argues for equity market volatility subsiding (assuming no further massive moves in oil prices in coming months).  That said, an extended period of flat yield curves and tight Fed policy may usher much higher volatility for both asset classes.