Ed Peters
March 2, 2022

Since Russia invaded Ukraine, stocks have declined while bonds have rallied in a manner often called “flight-to-quality.” The VIX has gone up as stocks have retreated, following the well-documented inverse relationship between stock returns and risk, as measured by implied volatility. However, as bonds have rallied, so has the MOVE index, which is a measure of the implied volatility for bonds. But isn’t this backwards? Isn’t an increase in the risk of bonds supposed to mean lower returns, just like stocks?

It turns out that for bonds, the relationship between implied volatility and return is more complicated than it is for stocks. Historically, almost all bond rallies accompanied by a high VIX have also resulted in a high MOVE index. The reason is that “flight-to-quality” doesn’t really exist. After the Global Financial Crisis of 2008, the Fed and the ECB (European Central Bank) found that when a crisis hits, the dynamics of the bond market change. Financial institutions, who are also the primary suppliers of bonds, retain more bonds for their own liquidity needs rather than selling them. In other words, the depth of the bond market declines as demand for bonds increases. This increases bid-ask spreads and results in higher bond volatility. Hence, the MOVE index goes up rather than down. The central banks also found that this behavior only affected recently issued, or “on-the-run” bonds. So older government bonds of the same quality, and maturing on the same dates, do not rally during these events. If these were really “flight-to-quality” events, then off-the-run bonds, which have lower liquidity but the same quality, should rally as well. But they don’t. So, it is liquidity rather than quality that’s driving the bond rally. It’s also telling that the MOVE index measures the implied volatility of on-the-run bonds only.

This means that the current bond rally, which is also accompanied by an elevated VIX and MOVE index, is likely due to concerns about liquidity, not necessarily safety. With restrictions placed on the Russian Central Bank and the likely strains that this will place on the global financial system, we may want to keep an eye on liquidity in the coming days.

Beber A, Brandt MW and Kavajecz, KA “Flight-to-Quality or Flight-to-Liquidity? Evidence from the Euro-Area Bond Market” Working Paper 2006
Engle R, Fleming M, Ghysels E, and Nguyen G, “Liquidity, Volatility, and Flights to Safety in the U.S. Treasury Market: Evidence from a New Class of Dynamic Order Book Models” Federal Reserve Bank of New York Staff Reports, no. 590 December 2012

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