Volatility a key driver of quality assets -Merrill

NEW YORK, April 5 (Reuters) - Forget the yield curve.

What will drive higher-quality stocks and bonds to outperform their lower-quality counterparts is market volatility, a leading strategist said on Thursday.

In a note to clients, Merrill Lynch's chief U.S. strategist, Richard Bernstein, said higher-quality stocks and bonds, typically those of larger-capitalization companies, will outperform lower-quality equities, or those of small-cap firms, because they've typically outperformed as the Wall Street's fear gauge, the VIX, has risen.

"We continue to believe that volatility will be a more significant driver of quality performance than will be the slope of the curve," Bernstein said.

Small-cap stocks and bonds tend to be of lower credit quality and have higher borrowing costs than large caps, which means they benefit disproportionately when the Federal Reserve has an easy monetary policy in place, as evidenced by a steep yield curve.

But Bernstein said although the yield curve has steepened again -- as long-dated Treasury yields trade above short-dated notes -- "it has not steepened enough to advocate an overweight of low-quality companies, in our view."

He said low-quality assets do not become the "truly dominant theme" until the 10-year to 2-year yield spread -- currently about 5 basis points -- widens to about 100 basis points.

"Our main theme for 2007 remains that volatility will increase as the year progresses largely because of continued uncertainty about global monetary policies," he added.

Indeed, the Chicago Board Options Exchange Volatility Index .VIX, is at recent lows although still above the 10 to 11 range it saw before the late February sell-off in stocks.

It is in a "new volatility regime" bounded to the downside by 12 and to the upside by 16, said Tim Biggam, options strategist at options brokerage firm Man Securities in Chicago.

"This tells us that investors are comfortable with current stock valuations although not nearly as complacent as they were before the market sell-off in late February," Biggam said.

Nevertheless, Bernstein said he and his colleagues have preferred higher quality assets for some time based purely on their undervaluation. "However, an increase in volatility might provide the catalyst for investors to finally appreciate these assets' significant undervaluation," he added.

(Additional reporting by Doris Frankel in Chicago)