Swedroe: Stock Volatility Moves Treasurys

October 21, 2015

Understanding the volatility of Treasury bond returns, as well as the volatility of both the level and slope of the Treasury term-structure, are fundamental issues in finance. What’s more, they have important implications for investors and portfolio design.

Researchers have offered both theory and empirical evidence that suggest important linkages between equity risk and the Treasury bond market.

For example, studies have found that greater economic uncertainty tends to lead to both higher equity volatility and an increased motive for precautionary savings that can depress interest rates. In addition, links connecting the stock and bond markets have been attributed to flight-to-quality or flight-from-quality (FTQ/FFQ) as some investors switch between riskier stocks and safer Treasurys following adjustments in their perception of risk.

Stock Volatility Can Induce Flight

Naresh Bansal, Robert Connolly and Chris Stivers—authors of the paper “Equity Volatility as a Determinant of Future Term-Structure Volatility,” which appeared in the September 2015 issue of the Journal of Financial Markets—contribute to the literature and our understanding of how the equity and bond markets interact.

They explain: “With linkages between the economic state and stock volatility, a higher stock volatility this month is likely to be associated both with more extreme stock price movements over the next month (volatility clustering), and with higher economic uncertainty and volatility in that uncertainty (stock volatility tending to be higher in stressful economic times with greater economic-state uncertainty). If a higher stock-return volatility and a higher time series variability in economic uncertainty are likely following months with a high realized stock volatility, then the likelihood of FTQ/FFQ pricing influences over the subsequent month is presumably much greater.”

They add: “The return volatility of both equities and bonds may be responding to some omitted factor or news that bears on the volatility of each asset class…. If there is volatility clustering in that common factor, then equity volatility may be providing an additional signal about the underlying volatility environment for subsequent bond returns.”

The study covers the period October 1997 through June 2013. The authors chose this date as their starting point because the literature indicates a clear change in the joint distribution of stock and bond returns around October 1997. Prior to October 1997, the quarterly correlation of the S&P 500 Index and Long-Term (20-year) Treasurys was positive (+0.18). From October 1997 through June 2013, the quarterly correlation was highly negative (-0.55).

In fact, the authors note: “Equity-risk dynamics and flight-to-quality pricing influences may be particularly important for understanding bond market dynamics over the post-1997 period since this period features a predominantly negative stock-bond-return correlation, a low inflation-risk environment, and several episodes of high and volatile equity risk.”

Analyzing Treasury Volatility

The authors analyzed the volatility of returns on long-term (30-year) and medium-term (10-year) Treasury futures contracts, volatility in the change of term-structure level, and volatility in the change of term-structure slope. The following is a summary of their findings:

  • Relatively high realized stock volatility in the previous month is reliably associated with higher subsequent stock volatility over the next month. For example, in the high-volatility state, the subsequent stock volatility was 33.3 percent versus 18.3 percent in the full sample, and 96.4 percent of these conditional stock volatilities were above the full-sample median. Alternatively, following months of low volatility, the conditional subsequent stock volatility was 9.9 percent, with only 5.1 percent of these conditional stock volatilities coming in above the full-sample median. In addition, the VIX is strikingly higher and more variable for observations that follow high realized stock volatility.
  • The conditional volatility of Treasury returns is also strikingly different, depending on whether the prior month’s stock volatility was extremely high or low. Treasury return volatilities that follow high stock volatility have a mean that’s about twice the comparable values for the observations that follow low stock volatility.
  • Lagged equity volatility is a substantial, reliable determinant of subsequent Treasury bond and Treasury note futures return volatility, and also of the subsequent volatility of the level and slope of the term structure.
  • Equity risk helps us to understand movements in the term structure, beyond an approach that looks only at the bond market in isolation.
  • Stock/bond return correlations are appreciably more negative for observations that follow high realized stock volatility.
  • FTQ/FFQ dynamics are a key contributor to the relationship between stock and bond market volatility. For example, a much stronger relationship exists during stressful, uncertain economic times (such as around recessions) when bond prices are likely to appreciate with heightened economic uncertainty because of a precautionary savings effect. In periods of low economic stress (the authors looked at two such periods: January 1993 to November 1996; and April 2004 to June 2007), the results indicate the lagged Treasury bond return volatility is the more important explanatory term.
  • The relationship remains strong when controlling for the lagged volatility of economic variables such as inflation and the default yield spread, variables that seem likely to be more linked to bond volatility but might also be embedded in equity volatility.


The authors’ finding that a stronger relationship occurs during periods of higher stress/volatility in the stock market is evidence that should be expected through the flight-to-quality avenue. Thus, there is an episodic nature of the time-varying relationship between stock and bond market volatility.

They also found that Treasury bonds have served as a good diversification instrument against bad stock market outcomes, and that such diversification benefits have been relatively stronger following periods with higher realized stock volatility. When the stock return was extreme, they found a sizably opposite average Treasury bond return.

The authors concluded: “The intertemporal aspect of our findings supports the notion that equity volatility can help understand volatility behavior in bond markets, beyond an approach that only looks at the bond market in isolation.”

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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