The US Bond Market Expects an End to QE

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Are we getting closer to the end of QE? The US bond market certainly thinks so. Overnight, the benchmark 10-year Treasury yield rose 14 basis points, to 2.72%. Market interest rates are now hovering around their highest levels in years.

As you can see in the chart below, yields haven’t been in this area since mid-2011. That’s when Greece and the euro crisis put a deflationary fear into markets worldwide. Yields plunged as capital fled Europe and went into the safety of US Treasury bonds (and gold).

After stabilising (sort of) for a while, in 2012 renewed concerns about Europe (this time Spain and Italy) saw more European capital flee into the US bond market. And as capital rushed in, it pushed prices up and yields down. 


Source: StockCharts

But the July 2012 plunge was the nadir. Soon after, Bernanke came out with QE3 and the European Central Bank’s Mario Draghi promised to do ‘whatever it takes’ to save the euro. Capital began to shift back to Europe, moving out of the US bond market.

In May this year, Treasury yields spiked higher on tapering talk, and the view in the market persists that the Fed will begin to reduce its purchases of treasury and mortgage bonds as soon as next month. If it does so, it will make for an interesting run to the end of the year.

Right now, we’re in the summer doldrums. Most of the northern hemisphere takes the month off for holidays and ignores the market. Trading volumes are low and markets are listless. But when everyone gets back to work in September, that’s when things pick up.

It’s probably why the September/October period has historically been one of the most volatile. And if the Fed announces the start of ‘tapering’ and a move to higher interest rates next month, you can bet that volatility will be back on.

If constant QE (since 2009) levitated US equity markets, it makes sense that the market won’t take too well to the end of QE. Then again, not a lot of stuff has made much sense these past few years. Not if you really think about it. The best bet is to not think about it.

Which is why the ‘QE = buy stocks’ trade has worked so well. It’s one that our mate Kris Sayce has employed to great effect. It’s why, since bottoming in March 2009, the S&P500 has increased by around 150%.

We’d say it’s due for a correction. It had a little one during May and June, but it was nothing major. The bulls quickly regained control and sent the index to new all-time highs. We’re talking about a decent correction, somewhere in the region of 20-30%. And with September/October upon us, we may just get it if the Fed bites the bullet and commits to tapering.

Keep in mind that we haven’t had the traditional September/October storm since 2008. Admittedly that was a big one and made up for quite a few mild years. But it’s worth keeping in mind as the stormy months approach.

It’s also worth keeping in mind that the US economy is completely addicted to cheap money. And while a 2.7% yield on the 10 year Treasury is hardly indicative of tight money, it may still come as a shock once it flows through the system.

So that could set us up for a sell-off in equity markets and a rally in Treasuries as the market realises that ever so slightly tighter money will slow the economy down.


Regards,

Greg Canavan+
for The Daily Reckoning Australia

Join The Daily Reckoning on Google+

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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slewie the pi-rat
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stop the economy!
i want to get off!

wpDiscuz
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