Wednesday, May 25, 2011
This chart compares the implied volatility of equity and Treasury options, and it's not surprising that they have been highly correlated over the past 5 years, since they reflect two sides of the same capital market. Implied volatility is a good proxy for the market's level of fear, uncertainty, and doubt, and as this chart shows, FUD is still somewhat elevated compared to the relatively tranquil days of 2006 and early 2007. I take this to be an indication that the market is still conservatively priced, still somewhat concerned that something might go wrong, and not overly optimistic.
It's also not surprising that the return to conditions of relative tranquility has been slow and gradual and not yet complete. "Once burned, twice shy," as the saying goes; the memory of the recent recession is still vivid, and there are still lots of things to worry about (e.g., trillion-dollar deficits and a gigantic increase in the monetary base).
As fear continues to slowly fade, to be replaced by increased confidence, equity prices should gradually rise and bond yields should rise as well, because increased confidence will lead to more investment, more jobs, and a stronger economy. Low Treasury yields are the market's way of expressing deep concern about the economy's ability to grow, so higher yields should naturally accompany an eventual improvement in the economic outlook.
Posted by Scott Grannis at 11:38 AM