The Relationship Between Volatility & Interest Rates

by Walter Johnson

Volatility usually refers to regular shifts in price and/or value in the stock and bond market. Currency markets and bonds are regulated by interest rates, which means that volatility and rates are one and the same phenomenon. Stocks, on the other hand, are different, since the effect of rates on stock prices or gains is less direct.

High Rates

When interest rates go up, investors see bonds as more profitable. This results in an increase in the short term bond market. In many cases, this also means that money is taken out of the stock market and placed in bonds. It is far more difficult to predict the effect of high rates on longer term bonds, since bonds that mature in two or three years could easily outlast the temporary spike in interest rates. Therefore, the primary effect is for short term bonds to see more money.

Low Rates

When rates go down, bonds seem less attractive for the short term. It is very possible that long term bonds might see a slight increase in volatility since money might go to them. This is because long term bonds in a situation of lower contemporary interest rates are normally predicted to increase in value. Long term bonds seem like a good investment when interest rates fall because a) they are temporarily cheaper and b) since rates will invariable go up, they will end up making a larger profit in the longer term. When rates go up or down, the various markets respond based on the expectation of investors. However, as uncertainty increases, volatility results, since investors do not share the same sentiment. Volatility in bond prices of stocks might indicate, therefore, investor uncertainty as to the future.

Volatility and Hedging

When bond prices are volatile, this strongly suggests that investors are not confident about future rates. Bond and currency holders might seek to hedge their investments by holding a mix of long and short term bonds as well as state-controlled currencies like the Chinese yuan. If volatility signals investor uncertainty or even cynicism, then interest rates may slightly increase so as to attract more money to debt financing. In turn, if volatility takes money and brings it to gold, oil or other commodities, this may also force rates slightly up to encourage more debt investment in the bond market.

Volatility and Uncertainty

Volatility is not a good sign for the economy. It stresses a lack of consensus in the markets as a whole. Stock options will almost always increase in value since stock volume increases. Gold and other commodities will almost always increase in value as well. In conditions of high domestic debt, such as in the U.S. in 2011, volatility in stock and bond markets may may force the Federal Reserve to increase rates and the "premium" for longer term bonds. The Fed may even go so far as to increase reserve requirements for banks to avoid the necessity of yet another bailout. Volatility in a high debt scenario can signal a total lack of faith in the domestic economy to carry the debt currently at issue. Again -- rates might increase, especially on the more uncertain long term bonds, so as to maintain the needed debt financing.

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