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VIX-Yield Curve: At the Door of High Volatility? We freely admit: Figure 1 is probably the strangest chart that you will ever see, at least in finance. You may be wondering: did they throw blue spaghetti noodle on paper for inspiration and then write an economics article about it? We assure you that neither is the case. The above chart represents three successive iterations of the VIX-yield curve cycle, a strange but powerful economic phenomenon that has persisted since at least the end of the 1980s and to which every fixed income and equity volatility trader should pay attention. We will break it down in much simpler fashion. As with any circular motion, where to begin is arbitrary, so we will begin at the bottom of the economic cycle and work our way to mid-stage expansion.
Early-stage recovery: yield curve remains steep, equity volatility begins to fall. Mid-stage expansion: the yield curve starts to flatten, equity volatility remains low. Late-stage expansion: yield curve becomes even flatter, equity volatility soars as fears of recession dominate investor behavior. The result is quite extraordinary: consistent counter-clockwise motion.
Steep, upward sloping yield curves with short-term rates much lower than long-term bond yields eventually are associated with an economic recovery and lower equity-market volatility. As already noted, the Fed has commenced removing monetary accommodation. VIX remains unperturbed at extraordinarily low levels. This phase may persist another year or so as the yield curve continues to flatten and the VIX, most likely, remains low for a while longer. The next phase is the late-stage economic expansion. By this time the yield curve will be quite flat.
What makes this cycle tick is the interplay of Fed policy and economic downturns. At the beginning of our cycle, rising unemployment in a recession triggers a Fed policy shift to much lower short-term interest rates. And, in some cases, the line of causality from late-stage economic expansion to recession is not so clear. In the late 1990s, there was the exuberance of a market fueled by rising technology stock valuations even as earnings from these companies were only growing slowly. The 2008-2009 economic disaster had a different story to tell.