The Low-Volatility Anomaly, Interest Rates, and the Canary in a Coal Mine

Abstract

Capital markets are interconnected. The low-volatility anomaly in equity markets can be partly attributed to changes in interest rates in fixed-income markets. The authors extend this contemporaneous relationship to serial relationships across time. They show that returns from the low-volatility anomaly in U.S. stocks have information about future changes in U.S. Treasury yields. Specifically, when low-volatility stocks outperform high-volatility stocks, Treasury yields tend to decline subsequently. This relationship does not seem to exist in the opposite direction. Trading strategies in U.S. Treasury note futures based on forecasting models using this relationship would have been profitable. Even though the common perception is that the bond market is more prescient than the equity market in terms of anticipating market movements and economic shocks, the authors show that in this instance, equity investors move ahead of bond investors and they are the canaries in the coal mine.