Volatility is coming and stock could be at risk

The Vix has risen sharply on Tuesday and is close to its highest level since June. After supressed volatility for most of October, see figure 1, have fears about the US Presidential election finally caught up with investors, and could US stock markets start to look vulnerable?

Bond yields triggering volatility

We think that the Vix is rising for a couple of reasons: 1, election fears, and 2, rising bond yields. The latter point could be more important in the long-term than the election risk, in our view. US 10-year Treasury yields are at their highest level since May, and the US yield curve (10-year yields minus 2-year yields), see figure 2, is at its highest rate since mid-May.

A steepening yield curve is usually the sign of a healthy economy, however, right now it is a cause for concern as economic growth in the US may not be strong enough to withstand a sharp rise in bond yields. In this environment rising bond yields may not be a sign of a positive economic outlook, and instead a sign of rising risk premiums. This is bad news for the stock market, which tends to come under pressure when bond yields rise.

The Fed could put upward pressure on bond yields

The risk is that bond yields may move even higher in the coming weeks. Right now, the market is pricing in a 75% chance of a rate hike from the Federal Reserve in December. Thus, if the Fed, who meets this week, signal that a rate hike next month is a done deal, then we could see further upward pressure on yields in the coming days as the market increases its bets that the Fed will hike rates before year end.

Libor increase a worry for the stock market

Stock investors are also watching the US Libor rate. US 3-month Libor has risen to its highest level since 2009 in recent days. Although Libor rates remain at historically low levels, the fact that many loans, including mortgages and corporate loans, are priced based on Libor rates, a multi-year high in Libor is likely to spook some in the stock market.

Further declines likely for US stocks

US stocks have been looking vulnerable for a while, and the S&P 500 recently fell below its 50 and 100-day moving averages. Stocks tend to fall when the Vix rises, thus we may see downward momentum start to build for US stocks in the near term. Key support lies at 2,080 – the 200-day sma. If US yields continue to rise then it could be a rocky few days for US indices and we may see a sharp sell-off as we lead into key event risks including Friday’s NFP report and next Tuesday’s US Presidential election. Get your hard hats at the ready…

Figure 1:

The Vix and the S&P 500 tend to move inversely to one another.

Source: City Index and Bloomberg

Figure 2:

Source: City Index and Bloomberg