Wednesday, November 18, 2009

Bond market volatility returns to "normal" levels

This chart highlights the attainment of yet another "milestone" in the market's recovery from last year's panic recession. This is the MOVE index as calculated by Merrill Lynch: a weighted average of the implied volatilities of 1-month options on 2, 5, 10, and 30-year Treasuries. The implied volatility of the bond market has now subsided to levels not seen since 2007, and it is even lower today than its average since 1990. (The Vix index of implied equity volatility is still above its lows of 2008, in contrast.)

Skeptics would be quick to note that today's low bond market volatility owes much to the Fed's insistence on keeping short-term interest rates low for a long time. Yet they have been saying much the same thing for the balance of this year, and that did not keep bond market volatility from skyrocketing.

When I combine today's relatively low level of bond market volatility with the observation that the market's expectation for 3-mo. Libor at the end of next year has fallen from 1.77% to 1.2% in just the past month, and that credit spreads remain well above normal levels, I conclude that the bond market has finally capitulated to the Fed's way of seeing things. That view of the world says that a) the economy is going to be very sluggish and could easily slip into at least a mild recession within the next year or so, and b) inflation is going to remain relatively low.

Since the bond market belongs to the same capital market in which equities reside and trade, it is hard to escape the corollary to the above conclusion: stocks are nowhere near "bubble" territory and in fact are still cheap if one believes that the economy can grow at some reasonable rate (3-4% being quite modest given the depth of the latest recession) and avoid another recession.

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