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Stress indicator: Why the bond market is the new fear index

Forget the Fear Index. Investors looking for an indicator of stock market stress should turn their eyes to the bond market.

The CBOE Volatility Index , or VIX, has long been a widely followed barometer of anxiety among equity traders.

But despite major market upheavals in recent weeks, the VIX – widely known as the Fear Index – has remained stuck in a narrow range between 15 and 20, well below the 40-plus levels it hit in late 2011.

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The VIX, which uses option prices to estimate investors' expectations for future volatility, seems to be reflecting traders' growing insensitivity to the steady stream of bad economic news from Europe.

Global bond markets have provided a much more useful read on market nerves, as plunging yields on government debt mirror concerns about stalling global growth and declining corporate profits.

Over the past two years, prices for U.S. Treasuries maturing in 10 years or longer have consistently moved in the opposite direction to Canadian stock prices.

Rising bond prices have foreshadowed stock market declines; falling bond prices have come before stock market gains.

This is a reversal of the pattern that used to hold before the financial crisis, when rising bond prices were generally regarded as a positive catalyst for stock markets, according to Douglas Porter, deputy chief economist at BMO Nesbitt Burns.

Bond prices and bond yields move in opposite directions, so higher bond prices imply lower yields.

Those low yields used to make equity returns more attractive in comparison to fixed income payouts.

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But since 2008, investors have responded to any concern about the global economy or corporate profits by moving into fixed-income investments, driving yields lower and bond prices higher.

Mr. Porter says that stronger bond markets are now viewed as a sign of a weakening global economy – a negative for stock prices.

The recent deterioration in global economic data, notably in Europe, has accelerated the flow of assets out of equity markets and into the relative haven of bonds issued by fiscally sound countries.

In countries like Germany, Switzerland and Denmark, the voracious demand for safety has resulted in soaring bond prices and negative yields in which investors essentially pay governments for the privilege of lending them money.

Massive asset flows into fixed-income instruments are also evident in the United States.

The ETF Industry Association reports that inflows to fixed income ETFs have totalled $33.5-billion (U.S.) in the year to date, 40 per cent more than for equity ETFs.

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In Europe, bond markets have signalled the severity of the region's financial crisis and provided useful clues as to which way global stocks will move next. Last week's temporary inversion of the Spanish yield curve, in which two-year yields rose above 10-year yields, was immediately followed by a sharp sell-off in global markets, including the S&P/TSX composite.

The inversion reflected rising concern that the government could default on short-term debt. When statements by European Central Bank president Mario Draghi reversed the slide in Spanish debt markets, global equity markets quickly bounced back.

Investors tempted to jump into the equity markets may want to wait for bond prices to halt their rapid climb.

Stable bond prices would signal an improving economic backdrop suited to higher profit growth.

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About the Author
Market Strategist

Scott Barlow is The Globe's in-house market strategist. He is a 20-year veteran of Canadian investment banks, including Merrill Lynch Canada, CIBC Wood Gundy and Macquarie Private Wealth (MPW). He was a highly ranked mutual fund analyst for 10 years and then, most recently, the head of a financial adviser support team at MPW. More

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