Markets have been in a slumber. Last month, the VIX index — essentially a measure of how nervous traders are about the coming 30 days — hit an all-time low. Look:
The lack of volatility in markets has had traders bored and muted news flow on moves in the major markets. Volatility has been only a touch higher here in Australia. The A-VIX, Australia’s equivalent of the US VIX, touched all-time lows this year but has lifted a little, thanks to some gyrations in commodity markets that have whipped around mining stocks, and the market getting its head around changes in the wings for the banking sector, mainly driven by the bank levy.
But that all could be about to change.
With the Federal Reserve lifting interest rates and the so-called Trump reflation trade unwinding, debt markets are starting to paint a less hopeful picture of the future direction of the world’s largest economy. The US yield curve, which reflects the difference between short-term and long-term debt, has been flattening. As Jonathan Garber explains in detail here, this has a perfect track record of predicting impending US recessions — and it has been edging closer to signalling that one may be on the cards (although it still has a bit to go before we need to sound the claxon).
So while a US downturn isn’t quite signalled yet, what we can say for sure is that a flattening yield curve is also a good predictor of market volatility. In a note to clients, Citi’s US equity strategy team offer this chart explaining that volatility looks set to return to markets.
This implies volatility is set to make a comeback in US markets, and others will follow to varying degrees.
The reasons it’s a predictor may be a little unnerving, as they are the same reasons that the yield curve can predict a recession: it means short-term credit is getting tighter because banks are concerned about companies, while at the same time demand for safe-haven assets is high.
For now, it’s signalling that some action is looking set to return to global stock indices.
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