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:
