Why is volatility so low? The simple answer is that financial market volatility is mostly driven by the credit cycle. When monetary conditions are loose – meaning credit is both available and cheap – market volatility tends to be lower. This relationship is evident when you compare equity market volatility with a proxy for credit market conditions, such as high yield spreads. In the past, the correlation between high yield spreads and equity market volatility has been roughly 80%.
Market Realist – The volatility index correlates with high yield spreads
The graph above shows both high yield spreads and the volatility index (VXX)(XIV). High yield spreads are the difference between the yields of high yield bonds (HYG)(JNK) and Treasuries (TLT) of the same maturity. The difference increases when high yield bonds’ risk of defaulting rises. This typically happens when the economy is hurting. This is when the credit markets are poor, which expands the spread as investors look for safety in Treasuries. The opposite happens when the economy’s booming.
The above graph suggests that the volatility index and high yield spreads highly correlate. This is logical since the volatility index tends to be high when the economy is in a standstill or recession. That’s when credit markets tend to freeze.
Today, short-term interest rates are still stuck at zero, real short-term rates are negative and companies are flush with cash. In other words, credit conditions are about as easy as they get, a fact reflected in very tight high yield spreads. With credit conditions this easy, you would expect a low volatility regime.