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What The VIX Says About This Market

Published 05/27/2014, 02:10 PM

For a long time after the financial crisis, the VIX and credit spreads, two different measures of risk aversion, both remained slightly elevated relative to historical levels that were reached in the 2003-2007 bull market.

In the 2003-2007 bull market, BBB credit spreads (as measured by the Bank of America Merrill Lynch index) hovered around 1%, but from 2010-2013 spreads could not fall much below 2%.  In 2014, spreads have finally broken through the 2% level and are now at 1.5%.  The VIX has also continued to fall this year and appears to be approaching similar lows that were reached in the 2003-2007 period.

The extra spread vs. the lows that were reached in 2006 represented the residual risk aversion that has lingered since the financial crisis.  The fact that both the VIX and credit spreads are approaching former lows indicates that the scars of the financial crisis may be finally starting to fade.  It took about six years for us to let our collective guard back down.

The decline in risk aversion represents growing headwind to future asset price increases though.  Over the past five years, asset prices have benefitted significantly from declining risk aversion.  Credit spreads at all time lows suggest that the juice from the “re-risking” trade has almost been completely squeezed (One could argue that there are still 50 bps left to go).  From here future equity price increases will be dependent on true earnings growth.  Returns on fixed income are at best likely to reflect the stated yield to maturity.

The Bank Of America Merrill Lynch Credit Spread Index
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