The stock market tends to garner all the attention, reacting sharply up and down to seemingly every news headline. But this year, the true excitement has been in the normally staid credit market, with Treasurys and corporate credit experiencing some of the highest levels of volatility since the 2008 financial crisis.
We believe these moves in fixed-income markets and underlying correlation structures are sending signals at odds with the relative placidity of global equity market indices. Equity markets appear to have shrugged off concerns after the Treasury backstopped Silicon Valley Bank and Signature Bank depositors. This rally has been concentrated in some of the more speculative equities, including Marathon Digital Holdings (Bitcoin proxy), Opendoor, and GameStop, which are +86%, +50% and +30% respectively since the backstop on March 13.
This volatility in credit markets deserves more attention: credit markets are about three times the size of equity markets and are the financial plumbing of the real economy.
Treasurys—the same safe-haven asset that might have brought down Silicon Valley Bank—saw a nearly four standard deviation rise in volatility. Figure 1 below shows realized volatility in 10-year Treasurys reaching levels previously only seen in March 2020, during the Eurozone debt crisis, and during the 2008 financial crisis.
Figure 1: US 10y Treasury Volatility
Source: FRED
The failure of Silicon Valley Bank caused a significant downward shift in the forward implied curve. We believe this led a strong rally in Treasurys as rate expectations came down. In fact, the two-year Treasury note had the single largest weekly move (-72bps) in over 10 years. This kind of Treasury volatility can have a chilling effect on corporate credit issuance, much of which is priced off Treasurys.
We saw this effect reflected in credit spreads, which also experienced a significant volatility spike. We closely track the high-yield spread, which we believe is the best macroeconomic indicator. In the immediate aftermath of the Silicon Valley Bank failure, the high-yield spread oscillated wildly as market participants adjusted to the instability in the banking sector. The only times the high-yield spread previously exhibited this level of volatility were in 2008 and 2020.
Figure 2: High-Yield Spread Volatility
Source: FRED. Note: Trailing five-day average of absolute volatility.
The US economy runs on credit. Risk aversion from bank lenders means fewer loans and more expensive capital for small and medium businesses. And once this tightening begins, it can become self-fulfilling. Ben Bernanke called it “the financial accelerator,” when financial markets themselves become the source of macroeconomic volatility due to the withdrawal of liquidity. High volatility—and therefore high uncertainty about credit availability—can have pernicious downstream consequences.
These swings in credit markets have also created challenges for investors who rely on stock-bond correlations to make investment decisions. Figure 3 below shows stock-bond correlations, which had risen sharply in 2022, falling two standard deviations in March 2023.
Figure 3: Stock-Bond Correlation Momentum
Source: Capital IQ
We think the right trade in 2022 was to short stocks and bonds together, as bonds had their worst year ever and the two asset classes traded in near tandem. But this reversed dramatically in March, prompting articles about the return of 60/40 and reminding investors of the role bonds can play in a diversified portfolio.
In recent weeks, the credit volatility in the aftermath of Silicon Valley Bank collapse has eased, fueling a rebound in corporate borrowing. And after spiking to near-crisis levels, the high-yield spread has gradually fallen back to 450bps, which is roughly the 10-year average. While the current fear seems to have abated, credit market volatility is a flashing warning sign, in our opinion, and equity markets appear to be rallying unhindered. Figure 4 below shows the NASDAQ 100 P/E with the UST 10-year yield, which has tracked together for most of 2022-2023 but recently diverged.
Figure 4: NASDAQ 100 P/E vs. US 10y Treasury Yield
Source: Capital IQ
We do not believe that Silicon Valley Bank, Signature Bank and a few trend-following hedge funds will be the only victims of credit volatility. We believe the real economy depends on reliable and predictable credit availability, which volatility is not conducive to. And while it’s too early to say whether the worst is behind us, the disconnect between equity and credit markets is notable.
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