The Tail That Wags the Dog: 3-Month T-Bill Yield and Market Volatility

McClellan Financial Publications  ( Original )
FEB 26, 2018

A huge part of the problem with the Fed’s market interference is that their actions are designed to accomplish basic, binary goals over the short term. But every action they take affects hundreds of components of the larger economy, and often not for years after whatever supposedly beneficial tinkering they’ve decided to do.

Movements in the VIX seem to lag movements in the 3-month T-Bill yield by about 2 years.  We are now just over 2 years advanced from the Dec. 16, 2015 FOMC meeting, when the Fed finally allowed the Fed Funds rate to be lifted from the “0 to 0.25%” target.  And right on schedule, we got a volatility spike on the 2-year echo point of that change.

If you drop a lit match onto a puddle of 30-weight motor oil, it might burn, or it might swallow the match.  If it burns, it won’t do so very fast.  30W oil is NOT very volatile.

Now if you drop a lit match onto a puddle of gasoline, you’re going to need to grow some new eyebrows.  You’ll get a big FAWOOMP!!, as well as a talking-to from the firefighters who come to bandage you up.  Gasoline is very volatile.

In each of these cases, the input stimulus is the same… a lit match. The response varies, though, according to the nature of the organic chemistry of the medium into which the match is dropped.

The stock market is very much the same.  A news item which might get no reaction in some periods gets a huge reaction in others.  The volatility of the market varies, and for reasons which seem entirely mysterious on the surface.  But if we find the key to unlock this mystery, the variability of volatility starts to make more sense.

Now that we have that spike, what’s next?  The plot of the 3-month T-Bill yield says that the VIX should pause for a while, and then start trending upward late in 2018.  We have been through higher T-Bill rates before, and we’ll get through this upcoming episode.  But the point to understand is that the era of single-digit VIX numbers is behind us.

ORIGINAL SOURCE: Volatility and Interest Rates by Tom McClellan at McClellan Financial Publications on 2/23/18