Implied Volatility (IV) is currently at a low level. IV Rank (IVR) is currently low too. Eventually, whether today or sometime down the road when stock prices are higher, there will likely be a sell off in the market and IV will rise. Should the sell off be sharp enough it is likely we will see a “Flight to Quality” in the Bonds and Bond Futures. What does this mean “Flight to Quality” for Bond yields and how does this affect the correlation between stocks and Bonds?
Tom began with a warning that this time things may be different and that Bonds may be the last place traders will want to put their money. The Yield Curve is seen by plotting the current yield of the shortest Treasury Securities, the 1 month T-Bill to the longest, the 30 year Bond. When we see a flight to quality we usually observe a flattening of the curve in which the yield on the 30 Year Bond and the longer dated Treasuries drops more in relation to the shorter term Treasuries. A graph showed the range of the curve over the past two years. Recently there has been some flattening.
During periods of medium to low IV for stocks, as represented by a VIX level below 20, there is no firm rule of thumb for a correlation between stocks and Bonds although it tends to be a slightly negative correlation. When the VIX climbs above 20 in relatively high IV situations, there is a strong negative correlation between the two. A table displayed how when the VIX is below 20 the average correlation is -0.25 and is negative 44% of the time but with the VIX above 20 the correlation is -0.60 and the correlation is negative 81% of the time. Thus when IV is low we don’t know if a long Bond position will be a hedge against long stocks but it is likely to be a hedge when IV is high and vice versa. Tom noted that he thinks the “wildcard” will be that if the market has a slow drift down you might not get this flight to quality in the Bonds that you have seen in the past. It may lean negative but not have any “umph” to it.
For more on Flights To Quality see:
Market Measures from August 25, 2016: "Flight to Quality During Turmoil"
Market Measures from February 23, 2016: "Gold | A Flight To Quality?"
Market Measures from June 27, 2016: "Trading Flights to Quality"
Watch this segment of Market Measures with Tom Sosnoff and Tony Battista for the valuable takeaways and a better understanding of both the yield curve and the correlation between stocks and Bonds under different volatility environments.
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