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Predicting Volatility With Interest Rates at Trader’s Narrative

This fascinating chart, from McClellan Financial, compares the CBOE volatility index (VIX) with the 2 year offset 90 day T-bill interest rate:

90 day t-bill rate compared to VIX

The chart may seem like mere coincidence or an example of curve fitting. But I can think of two explanations for a link between these two series. First, when you have the Fed setting rates very low, investors naturally seek out ways to generate yield by accepting some risk. One very common strategy is to use options to increase the yield on blue chips which already provide some yield through dividends. As billions and billions of dollars gets shifted towards these strategies, the supply of options increases, thereby decreasing volatility.

The other rationale for a link between the interest rates and volatility is a bit more tenuous. In a very low interest rate environment, the central bank is punishing saving and rewarding speculative activity. When investors and traders heed this incentive, there is a market correction with a time lag of about 2 years which sends up fear and therefore the demand for protective options. If you have a better explanation drop me a note below.

The oracle of Baupost Group, Seth Klarman, said basically the same thing at the recent CFA Institute annual meeting in Boston:

“By holding interest rates at zero, the government is basically tricking the population into going long on just about every kind of security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can’t stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate.”

So what is Klarman buying in such an artificial financial environment? He’s sticking to Graham and Dodd “undervalued” securities and for catastrophic protection he’s buying way out-of-the-money puts on bonds. Why not gold, you might ask. It turns out that as a contrarian investor he believes that gold is expensive “near its all time high”. Instead he recommends whatever is “out of favor, loathed and despised”. The Euro fits the bill right now with a DSI of just 2% compared to 98% for gold (Gold & Euro Sentiment).

Returning to the topic of volatility, here is a chart of the S&P 500 index compared to the relative volatility at 50 and 200 day moving averages:

relative VIXs compared to SPX May 2010

Similar to other indicators which suggest that the current market environment is reminiscent of the 2008 crisis, the relative VIX has not been this high since October-November 2008. And just as the relationship with the 90 day T-bill suggets, volatility has spiked and will now recede.

The only way that volatility would continue to go even higher is if we had another waterfall decline or crash. Everything is possible of course but I think the probability of that scenario is low, especially considering the way that bullish sentiment has responded to the recent stock price declines.

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2 Responses to “Predicting Volatility With Interest Rates”  

  1. 1 Kalle

    Interesting. I run it through and got the following correlations:
    1992-1999 21%;

    1990-2010May 36%.

    1999-2010May 64%;

    Well it seems that it is a bit like curve fitting as it wasn’t much of an indicator before 2000.

  2. 2 PWR

    First, I want to say I find your site to be very informative and we seem to share a similar thought process. I haven’t yet had the chance to examine the t-bill/vix corr, however the VIX compared to moving averages is especially interesting. Puts things in perspective. I use a VIX move 1.5 and 2 std dev above and below the 10 day ma as one of my market timing gauges. Recently we stretched above the 2.0 threshold twice, which is a rare event.

    If you take down the timeframe on your charts to a 60 minute chart of the S&P futures you will see an Inverted-head-and-shoulders pattern or triangle pattern taking shape. This micro-view suggest the hammer on the daily could very well hold its ground.

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