Market risk, volatility, and business cycles

Market risk, volatility, and business cycles

We know that exogenous factors, such as major geopolitical events (wars, trade wars, regional conflicts, invasions etc.), can and did create significant volatility. For example, a geopolitical tension, even at a regional scale, can disrupt the oil market by decreasing oil supply. The collapse of Lehman Brothers exacerbated financial crisis and caused big volatility in global financial markets.

Aside from these external factors, market volatility tends to have patterns following business cycles. analyze the relationship between market risks and business cycles, we can look at VIX chart. VIX which is based on stock index option prices indicates near term market expectation of volatility. We can observe several patterns. During good times, the volatility is perceived to be low by market participants. This implies that in the early-recovery phase when economic environment is good, VIX tends to be between 10 and 20. At least, this was the case during the last 30 years.

VIX tends to increase from teens to 20 to 30 range during the late cycle when economic conditions start to deteriorate and show signs of weakness. Recessions are when turbulence in financial markets spike which push the index value above 30.

VIX index displays relationship with the yield curve spread which refers to the difference between the 10-year Treasury bond yield and Fed funds rate. This should not be surprising because the level of yield curve spread indicates the degree of tightening policy which impacts the whole economy. The relationship is that when Fed hikes interest rates and thus the yield curve eventually inverts, it is followed by more than normal market volatility two years later. We know that an inverted yield curve signals a recession which is the period when volatility in the markets spikes drastically.

Conversely, when monetary policy is accommodative, which is the case during a recession, we can expect long periods of low market volatility. So, an inverted yield curve portends increased market volatility while a (more-than-normal) steep curve signals dampened volatility.

Another measure of market volatility is St. Louis Fed’s stress index. To create the index, the St. Louis Federal Reserve Bank extracts information from 18 weekly time series. Some of these indicators are interest rates, yield spreads, and credit spreads. The chart shows that during the mid-cycle financial stress tends to fall below the normal level. At some point towards late-cycle excesses start to accumulate. Then, when monetary policy is getting tight, volatility in markets rise above the normal level. Financial stress remains elevated during this period, and peaks during a recession.