An unusual divergence between two market indicators â equity-market volatility and credit spreads â is flashing âmind the gapâ signals, according to Bank of America.
A gauge of equity-market volatility, known as the VIX, and corporate-credit spreads â two market gauges that traditionally move in tandem â have recently diverged, as the following chart shows.
Bank of Americaâs
Â analysts called this phenomenon a âstriking decoupling,â in a report released Monday, adding that the last time it happened, in mid-August 2015, what followed was a correction in the form of a stock-market selloff.
Credit spreads are a gauge of the market-implied default risk in the corporate bond market. Narrowing spreads reflect the marketâs confidence that defaults are becoming less common or less probable, an indication of an improvement in the marketâs perception of credit quality.
On the other hand, the Chicago Board Options Exchangeâs Volatility Index
also known as Wall Streetâs âfear gauge,â is a measure of expected equity-market volatility over the next 30 days and is calculated using the implied volatility of S&P 500 index options.
Though the two gauges refer to different markets, they have historically moved in tandem and they are both inversely correlated with the S&P 500
The VIX historically spikes at times of market stress, such as the dismal beginning to this year, and moves lower when equities post strong performance, such as during the recent rally that brought the S&P and the Dow industrials
Â near record highs from their mid-February lows.
On the other hand, credit spreads â which represent the yield differential between corporate bonds and U.S. Treasurys of similar maturity â also tend to be inversely correlated with the S&P.
In the above chart, Bank of America’s analysts tracked the average spread of the yield of a 10-year industrial corporate bond, excluding energy and materials companiesâ bonds, to the benchmark 10-year Treasury yield
As the chart shows, spreads widen in times of market turmoil when investors have little appetite for risk and require a higher compensation, or yield, to buy corporate bonds. Conversely, spreads tend to narrow when risk assets are gaining.
The recent divergence between the VIX and corporate bond spreads is a head scratcher, according to Bank of America analysts, as credit spreads have tightened sharply in April while equity-market volatility has not followed the downtrend.
So what is behind this anomaly?
According to Bank of America, the most probable explanation is that bond spreads have tightened excessively due to the âexcess demandâ for U.S. corporate bonds from foreign investors who are fleeing ultra-low and negative interest rates in Europe and Japan.
âThe foreign demand part of the equation is becoming particularly obvious as some of the biggest Japanese investors â including life insurance companies â have recently publicly announced expanded investments in foreign bonds for the new fiscal year that began April 1,â according to the report.
The top 10 Japanese life insurance companies alone plan to buy $46.6 billion of foreign bonds in the current fiscal year, the Nikkei reported last week.
Through negative interest rates and quantitative easing, the Bank of Japan âhas more or less purged the Japanese fixed income market for yield. As a result Japanese fixed investors â such as insurance companies and banks â are in a very challenging position where they are forced to buy foreign fixed income instead,â Bank of Americaâs analysts wrote last week, after the BOJâs decision to stand pat on interest rates rattled global markets.