Calmer Bonds Will Help Stocks

Originally posted on December 8, 2022

Russ Koesterich, CFA, Managing Director and Portfolio Manager, of the Global Allocation team discusses the importance not just of rates, but rate volatility.

For most of 2022, stocks and bonds have been intimately linked. As we look towards the end of the year, their fortunes remain intertwined, with yields falling and stocks rising. By late November, the S&P 500 had risen approximately 15% from its intraday low on October 13th, with stocks supported by lower yields and a somewhat calmer bond market. One indication of the latter: the MOVE Index, which tracks Treasury volatility, peaked the day before stocks bottomed.

Going forward, a key question for investors is this: Can yields and yield vol remain contained? Last summer’s rally hit a wall when Federal Reserve officials pushed back on dovish expectations. That sent rates and volatility soaring (see Chart 1).

Today, markets seem more aligned with the central bank’s intentions, and we’re arguably closer to the end of the tightening cycle. If this leads to lower rates and less volatility, stocks will have an easier time building on recent gains.

Note: MOVE Index is a measure of implied volatility on 1-month U.S. Treasury options.

As discussed in previous blogs, this year is notable for bonds transitioning from a risk mitigant to a source of risk. One way to measure this is by tracking bond market volatility. Late last year, the MOVE Index was in the high ’70s, modestly below the 20-year average. Bond market volatility started to spike in January and has been moving higher for most of the year, peaking in the summer and again in the fall at levels last reached at the height of the pandemic.

Consistent with history, the shift in the rate regime has been associated with a miserable year for stocks. Looking back at the past 20 years, equity returns have consistently demonstrated a significant, linear relationship with both the level and change in the MOVE Index.

Historically, when the MOVE Index is more than 1 standard deviation (sigma) below average, indicating a quiescent bond market, the S&P 500 gains an average of approximately 2.50% per month. Returns steadily drop as rate vol rises. When rate vol is more than 1 sigma above average, as it has been for much of the past eight months, average monthly returns are -1%.

Not only does the level of rate vol matter but so does the change. In months when bond market volatility is rising, the average and median returns for the S&P 500 are negative. In months when rate vol is falling, the S&P 500 average and median return is roughly 1.50%.

This may be good news for the stock market. Rate vol does not need to collapse; a grind lower may be enough to support stocks. Even if bond volatility remains elevated, the fact that we’re beginning to see the contours of a Fed pause should provide some moderation in rate volatility. To the extent that happens, this should remove a major headwind for stocks and (hopefully) set up investors for a better 2023.

This post originally appeared on the iShares Market Insights.

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.