The US Bond Market Expects an End to QE

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.

US Treasury Yield
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.



Greg Canavan+
for Markets and Money


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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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