It appears to us that market movements are becoming more independent and that previous correlations are breaking down. To help illustrate this point, the first chart below shows the S&P 500 and the USD/JPY exchange rate.
These two markets were tightly correlated between early December and early February but since then the S&P 500 has made very decent gains whereas the USD/JPY exchange rate has failed to rally. Ithas made very decent gains whereas the USD/JPY exchange rate has failed to rally is interesting because the main reason that these two markets were correlated in the first place is that they were both seen as a "risk on" trade.
The message from the earlier correlated period is as follows; when the Fed was printing money (which of course they still are) then investors were happy to switch out of bonds and into equities. At the same time, the USD/JPY exchange rate was seen as a risk on trade by those expressing a bullish view on Japanese equities as Abenomics injected some inflation into Japanese assets and economy via currency depreciation.
Another illustration of a previously held correlation is shown in the chart below. This time, we have compared the performance of the S&P 500 and the yield on the US 10 Year Treasury bond. The story is the same; a previously tight correlation broke down in early February.
This is the most interesting to chart to us. The narrative from the Fed that QE has helped push down interest rates just does not stand up to scrutiny - in fact, it can be argued that QE has caused interest rates to rise! In the chart below, we have plotted the 10 year US Treasury yield with the Fed's balance sheet and have marked on the charts the different episodes of how the Fed's balance sheet has evolved.
Yields did decline somewhat during QE1, but arguably, the decline actually happened during the Spring of 2010 as the equity market struggled when Europe wobbled and investors therefore sought safety in US Treasuries. During QE2 and QEternity, yields rose. During periods when the Fed's balance sheet was not expanding yields fell as economic growth stalled, the equity market declined leaving investors to seek safety in bonds. Arguably, yields were steady during Operation Twist, but as this was QE by the back door, we would argue that investors were more interested in switching out of bonds and into equities. Since the Fed began to taper the QE programme, the correlation between a rising Fed balance sheet and a rising equity market has remained perfect, and yet yields are falling. What is happening here and is there a message for investors?
One argument that should be put to bed is that the Fed will slow down the tapering if the economy stumbles. If the equity market is outperforming because of a belief that the Fed will slow tapering as data shows a soft US economy, then equity investors could be in for a nasty shock. We believe the hurdle for the Fed to change course and not to end QE this year is very high. In fact, there is a good case to be made that, with the equity market gains continuing to deepen the income disparity problem in the US, the Fed may have to address this by ending QE sooner than the market currently believes. Should this cause a market correction or a bear market then so be it. There are now enough FOMC members who worry about the efficacy of QE and how it is distorting financial markets so QE will end this year.
The question for investors is twofold. First, will markets react as they have before to no QE, i.e. equity market and bond yields down. Secondly, will the economy suffer a relapse at the same time. Of course, the markets and the economy may well survive the ending of QE and prosper, but we continue to believe that equity markets are fundamentally overvalued and the upside is limited even in the event that the QE experiments ends relatively benignly.
In fact, the message we want to end with is that the breaking down of correlations may well be market signals that markets are beginning to discount the end of QE. US equities are the last asset benefiting from Fed liquidity. We still view equities as vulnerable, and "renting" bonds and owning some Gold will prove ultimately to be a very reasonable proposition from here.