Back in May of this year I published an article wrote an article showing how the Federal Reserve's policies over the last few years had brought about significant market distortions. (It would only be fair at this point if I also pointed out that the last sentence of that article ended with my assertion that "I don't think he [Bernanke] will be taking the foot off the QE pedal anytime too soon" - it's nice to get things right!)
The most telling and striking part of the article was the graph I had constructed showing the interaction of the S&P 500 (SPY) over the last 15 years against the yield of the 10-year Treasury (ITE) over the same time period. The 10-year Treasury is inverted so that a rally in bonds is shown in the same direction as a rally in the equity index.
I've reproduced the graph here (above). To remind readers, traditionally, equities and government bonds move in opposite directions to each other - or in mathematical terms, they are said to be negatively correlated. One (equities) are perceived to be a risky investment that rally in times of optimism, or 'risk-on', while the other (government bonds) are perceived to be a safe harbor in risky times and a place to put your money when things are looking less rosy.
As I pointed out in May, up until 2009 the chart reflects this quite nicely - at times when the S&P is rallying the government bonds are selling-off, and the reverse holds true. In fact, you could almost see the two line up until 2009 as a nice reflection of each other.
But the striking thing about the graph is that it shows what happened once the Fed embarked on its first round of QE back in November 2009 (shown with an arrow on the chart). Almost immediately, the traditional negative correlation between equities and Treasuries disappeared completely and both began to rally in an almost identical fashion. The chart shows very clearly what was being referred to as the 'Great Levitation' act - the fact that asset prices are being supported artificially with risk having been removed from the table as a consideration for investors.
So, that's where we were back in May - the responses to the article were overwhelmingly positive and interested in this perspective. So, I thought given that we are several months further down the line it would be well worth updating the analysis and seeing what has happened since.
Below is an update of exactly the same graph, zoomed in a bit to start from just before the Fed started QE and updated to the beginning of this week, covering a total of just over five years.
Again we see the point I stressed in the original article - the fact that as soon as QE began all sort of correlation disappeared from these two markets, risk was taken off the table, and both equities and bonds marched in lockstep merrily upwards.
Then in May 2013 things began to change - taper moved from its innocent and humble meaning as a small long wick used for lighting candles, to being a word that had the power to occupy hours of economic discussions and columns of news print.
Look what has happened since May, when Bernanke first hinted that QE may be coming to an end - and tapering may begin. (As a reminder, Bernanke said before the Congressional Joint Economic Committee, that "if we see continued improvement and we have confidence that that's going to be sustained then we could in the next few meetings take a step down in our pace of purchases.")
This point is shown by the second arrow on the graph, and what we see is quite remarkable. The minute the Fed hinted that it would be taking the punchbowl away from the party (if I can steal Greenspan's apt phrase) it was game off - risk came back into the markets, bonds experienced some of their biggest losses over the last 30 years and the traditional correlation between equities and bonds re-asserted itself again.
It may be a simple diagram, but sometimes it's true that a picture (well, a graph) can paint a thousand words, and I think this one shows clearly and succinctly how big a role the Fed's QE policies have had on two of the world's major markets.
But ... following the Fed's decision to wrong-foot the markets at their September policy meeting, and not in fact start tapering, the big question is has Bernanke perhaps brought QE back from the dead? Has he driven a nail into the tapering coffin (for 2013 at least), implying that it may be around for longer than the market was expecting, and is it game (risk) back on? Are we going to see a re-coupling of the correlation between equities and stocks that has been absent over the last six months? And if so, are we going to see equities falling significantly or bonds rallying once again to their previous lows?
Well, my feeling is that it will be a bit of both. But I'll be happy to update this graph and analysis in another six months and see where we stand.