The US sovereign bond market is traditionally viewed as a safe-haven by investors. When US equity markets are under stress, investors generally purchase US Treasury bonds, pushing yields lower and bonds higher.  Traders seeking convexity prefer buying the long-end of the yield curve, which causes the curve to flatten.  This demand shock generally causes volatility to increase in US Treasury market instruments, like the TLT ETF.

US equities experienced intense selling pressure in September with corresponding spikes in short-term realized and implied volatilities.  Given the circumstances, it would be reasonable to expect a significant surge in the volatility of the TLT.  So far, this has not materialized.  Currently, the volatility of the TLT is close to its historical lows, with the 5-day Average True Range (ATR) of this ETF now below its 10thpercentile. You can see this in Figure 1 below.  (Please note this paper was written yesterday, so today’s activity has made the numbers a little stale.)  

The contraction in the volatility of the TLT in association with significant fluctuations in the US equity market and corresponding higher implied volatility values in equities is not normal. 

Figure 2 further shows how the VIX and the TLT ATR(5) are related. You can see that increases in the VIX are generally accompanied by increases in the volatility of the TLT. With the VIX close to 30, we would expect the TLT to be significantly more volatile, but its volatility is almost as low as it has ever been for a VIX value this high. 

Figure 3 calculates the VIX/TLT ATR(5) ratio to give you a more in-depth perspective. This graph highlights how extreme the current situation is, with the value of this ratio currently above its 99thpercentile. This event is so rare that there are only 45 days since 2002 when this ratio has been above 4000.  

It is interesting to wonder what the market has done historically when this rare phenomenon has happened. Figure 4 shows the 21-day percent change in both the TLT short-term volatility and the VIX, 21 days after the VIX/ATR ratio has been above 4000. In most cases, the VIX has decreased within the next month, while volatility in longer-dated US Treasuries increased dramatically, often more than doubling from its lows. The mean increase for US Treasury volatility is around 37%, while the VIX’s mean value decreases by approximately 15%. With the VIX/ATR ratio this high, there has only been one instance when short-term volatility of the TLT coupled with an increase of the VIX, which was 11-28-2018.

In terms of directionality, both the US Treasury and the US equity markets show mixed behavior following this type of volatility compression in the US Treasuries, see Figure 5. Moves in the SPY have historically been larger than the corresponding movements in the TLT.  This has been the case even when equity markets move lower.  However, it is worth noting that nearly all these events preceded the financial crisis, with only a handful of such compression events happening after 2008. During the financial crisis, a similar compression occurred in the fall of 2008, followed by an incredible increase in longer-dated US Treasury bonds with gains in the 20% range for the most significant month-to-month increase during this time. 

The takeaway from the above analysis is that the US Treasury market’s short-term volatility is at historic lows, and its ratio with the VIX is at even more extreme levels. This means that we are likely to experience a significant increase in US Treasury market volatility within the following month.  A +/-5% move in either direction is well within historical expectations. Since 2008 these moves have been more extreme, and – if the uncertainty of the current scenario rivals that of the financial crisis – we could see a particularly important rally develop in longer-dated US Treasury bonds before election day.