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Correction or Crash? Back To Watching The 10 Year

Posted
2/6/2014 9:59:00 AM
By: Martin Tillier
Referenced Stocks:IEF

Volatility has returned to the US stock market with a vengeance in the last couple of weeks. This has investors who clearly remember the events of 2008/9 worried. Are we seeing a correction, or the beginnings of a crash? I am pleased to say that, while that will only really be clear with the absolute clarity that hindsight affords, at least a trusted indicator is beginning to behave normally and may give us a clue.

On several occasions over the last few years, I have used the platform afforded to me here to complain bitterly about the topsy-turvy world in which we have been living. Good economic news would cause the market to falter (at least in the short term) as traders’ fear of a reduction in QE proved more powerful than any recovery, and bad news would spark rallies.

Less obvious to many but in some ways more upsetting to an old trader like me was the break-down in the inverse relationship between stocks and bonds.

The distortion that the Fed’s actions caused meant that bonds and stocks would often move in the same way. If Quantitative Easing looked to be threatened both bond and stock prices would fall in unison. This makes sense when the mechanics of QE are considered.

The Fed wanted to keep interest rates low, add cash to the economy and encourage investment in the private, rather than public, sector. All of this was (and still is) achieved in one fell swoop by creating money with which to buy Treasuries from financial institutions.

The presence of a huge buyer (The Fed) in the bond market keeps prices high and therefore yields (interest rates) low. The money handed to the banks in exchange for the bonds has to go somewhere and with bond yields low, that lends support to the stock market.

The problem with all of this, for those of us who were taught that everything reacts to movement in the US Treasury market, is that this scenario creates a situation where the traditional drivers of that market (current and expected global economic conditions) are pushed out. All that matters is to what extent QE will continue. This, in turn, makes Treasuries a terrible indicator for other markets.

What should happen is that when worry abounds, money seeks safety in US Government paper, pushing prices up. The converse is also true, when prospects are good money moves from the low yield of safe bonds to more risky assets such as stocks.

In that case, prices of Treasuries and stocks should, by definition move in opposite directions. The chart below shows the comparative performance of -the S&P and the iShares 7-10 Year Treasury ETF (IEF). As you can see, until as recently as October of last year, prices in both were often moving in unison.

Chart 1

Fortunately, tapering, the beginning of the end of QE, has meant that the US Treasury market is showing signs of returning to its old role as the ultimate indicator of market sentiment. If you look at the beginning of this year you will see that the big drop in stocks was preceded by a sustained move up in 10 Year Treasury prices.

That chart goes up until the end of last week, but if we look at what has happened since the beginning of this week, there are definitely encouraging signs.

While the S&P 500 has continued to fall this week, 10 Year Treasury prices have stopped going up; in fact they have started to drift lower. In part this is because yields (which move in the opposite direction to prices in any fixed income or bond market) found significant support at around 2.6%, but if the big money was convinced that a collapse was coming, no technical level would stop yields falling and Treasury prices rising.

Nothing, of course is for sure in this or any other analysis of markets. When we make decisions as to what to do with our money we have to weigh the evidence we have and the probabilities they indicate. The fact that US Government bonds seem to be reclaiming their role as an indicator of sentiment and that the drop in that market has been arrested, leads me to the conclusion that what we have been watching is a correction, not a collapse.

My advice, then, would be to treat this as a buying opportunity, but to keep a wary eye on 10 Year Treasury prices. The Fed is still a huge presence in the bond market, but if recent evidence is to be believed the 10 Year Treasury has returned to its role as a reasonable indicator of sentiment and will likely give advance warning if things turn even uglier.