Bonds And Equity Correlation
by Peter Cherry http://www.investmentwarehouse.com
No one knows how long this will last or how severe it will be, but the prior disinflation cycle has now finished. We have noted on numerous occasions that it is impossible to have benign inflation forever and that economic cycles will always move in and out of the ideal economic environment. Johannesburg, South Africa ~ As equity markets continue to power ahead, we have seen a weakening of US Treasury bonds this week. Does the bond market know something we don't and is this an important junction? The long economic cycle we entered into in 2000 is one of deflation, falling interest rates and rising unemployment.
The positive correlation seen in the past cycle between equity and bonds will break down as we continue in a primary bond bull market, whilst equities enter into a primary bear market. However, this week we have seen bond prices weaken in the US as investors become nervous about stronger than expected economic numbers. We have regularly pointed out that the bond market is a better interpreter of economic information than equity markets so what is going on?
The 10 year yield has risen from 3.07% to 3.36% and the long bond has also weakened Materially from 4.17% to 4.40%. The inflation adjusted 10 year note was at 1.54% earlier in the week clearly showing the bond market is not concerned about inflation but more the lack of it. However, the stochastic for bonds has turned down, the 21-day rate of change has turned down, so is this the beginning of the end for bonds? The bond market has definitely become nervous in the short term and newspapers claim that the perception of only a 25bpts rate cut at the next FOMC meeting instead of 50bpts, is the reason.
In the medium term, foreign banks, particularly from Asia, continue to buy US Treasuries with their massive current account surpluses and Greenspan continues to walk the lower interest rate talk. Many commentators are forecasting a bond market correction as we reach 40 year yield lows but with such buying pressure and deflation still a major concern, this is considered unlikely. Japanese 10 year bonds still yield 0.5% today. Declining bond prices means rising long rates, and rising long rates to the mortgage business is a major problem. Perhaps the bond market will rise in the short term providing the catalyst required to correct the expensively priced equity and property markets? Greenspan and the U.S Fed are certainly trying to avoid such a scenario.
Finally, all the factors behind the past 12 month's strength in Treasuries suggests there is little risk of a major rise in yields unless there is a clear pick-up in economic activity. In our view that's not likely and we should see yields continue to trend down. As we are in a primary bull market for bonds, short-term weakness becomes a buying opportunity. Members of the media are invited to visit http://www.investmentwarehouse.com for more information.
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