Archive | March, 2011

What the bond yield tells us…

13 Mar

Bond yields always tell a nice story. Have a look at the graph below,

In 1Q2010, the 10 year US government bond yield was in excess of 3.5%. A higher long term bond yield can indicate optimism about the heath of an economy. There are several hypothesis for the same, one of them being that interest rate on long term bonds contains information about future short term rates. A low long term interest rate is an indication of lower short term rates. Short term interest rates are low in a recessionary economy, as an economy in downturn is characterized by low inflation. Also the monetary authority of a recessionary economy will hold down the interest rates as part of a counter cyclical monetary policy. Going by this logic, in 1Q2010 , investors were generally sanguine about the growth prospects of the US economy. This is also confirmed by the rally in S&P  500 between February and May 2010.

The rally in developed markets (DM) helped lift sentiment in emerging markets (EM) with the iShare MSCI EM exchange traded fund gaining in the same period. MSCI EM is a benchmark used to monitor equity performance in emerging markets. Since histroical price data for this proprietory index is not publicly available, I have used the performance of iShare MSCI EM exchange traded fund which tracks the MSCI EM index.

In 2Q2010, structural issues in developed economies came to the front. The burgeoning US government debt and sticky unemployment figures spooked markets. Combined with the sovereign debt crisis in the Euro region, a bear market set in. The 10 year yield fell from a high of 4% to 2.4% in October 2010 and the S&p 500 also corrected during the period. Out of investor fear in developed economies, a rotation trade started with investors pushing up EM equity at the expense of DM equity. The iShare MSCI EM ETF gained around 25% in 2Q2010.

Then came October 2010 and everything changed. Just when investors had written off DM equity as an asset class, the mood suddenly turned bullish. There was widespread expectations of a second round of quantitative easing by the Fed and the investors started pricing that towards the close of 2Q2010. As expected, the Fed announced an asset purchase policy of US$600 bn on November 5th. The 10 year yield rallied close to a high of 3.8% by February 2010 and the S&P500 returned 15% in the the 5 months since October 2010. And yes, the rotation trade reversed with EM equity under performing DM equity. Investors were beginning to get concerned with rising inflation in emerging markets in 3Q2010. This coupled with the better outlook of the US economy took the sheen off equity markets in EM.

If you read my previous post ‘The real motive behind QE2‘, I had mentioned ¬†that an asset purchase policy should lead to a fall in yields as the government buys back bonds, pushing up their prices and lowering yields. This was also the official reason given by the Fed for the asset purchase programme – to lower long term borrowing costs. The exact opposite happened. Bond yields soared. However, nobody was complaining as the higher bond yields were interpreted as improving outlook for the US economy.

Now, where are we in March 2011. If you look at the graphs, you will see that the bond yield is now falling and the S&P500 is correcting. Does this herald an end of the QE2 backed short term optimism? If the mood turns bearish, will there be another QE3? Will the weakness in DM equity bring down EM equity with it? Or will a rotation trade emerge with investors moving money from developed markets to emerging markets?

All questions worth pondering on…