What happens if the volatility in the equity market increases? Does interest rates move up or down?

Question

I think both can happen and here is my reasoning. Please correct me if I am wrong.

During times of increased volatility in the equity market, investors adopt a more risk-averse approach and gravitate towards safer assets (bonds) to safeguard their investments. As a consequence, there is a tendency for interest rates to decrease since demand for bonds increases.

But can increased volatility can actually lead to higher interest rates? This is when investors demand higher risk premiums in order to compensate for the increased risk.

I am confused now. I don't know if I made any logical errors here.

Answer 1

Anything can happen... Historical correlations occasionally break down.

In general, I would expect yields to go down in a risk-off/flight-to-safety situation.

At the same time, short-term yields might outperform long-term yields (steepening yield curve) as investors avoid duration. Since there is no single rate (except the one set by the FOMC), it's hard to make predictions with certainty.

In an extreme scenario, yields may rise at the same time as equities sell off, if investors dump any/all liquid assets to raise cash (think COVID-19 pandemic)

Similarly, front-end yields rose dramatically in May 2023 as investors avoided bills most at risk from the US debt ceiling crisis, while equities moved more or less independently.