In May, the Fed signalled the beginning of the end of QE when it started, rather prematurely, to talk of tapering. The extent markets are nervous and uncertain can be measured in the subsequent reaction, which saw yields rise sharply and sparked mini-crises across many emerging markets at the prospect of a stronger dollar. Although markets know yields will normalise, few were ready for the inflection point to arrive as early as the Fed was signalling it might.
“Interest rates are at historical lows,” says Kateryna Taousse, associate director at Pacific Alternative Asset Management Company (PAAMCO). “It is impossible to predict when the spike will occur, but eventually rates will have to increase. The market moves around the taper talk is a good indicator of just how sensitive markets are to factors that could lead to a spike in rates.”
The result is a market driven by US data, hanging on every word uttered by the Fed. Yet, one of the main outcomes of the Fed’s taper experiment over the summer is a greater unease and uncertainty about Fed policy. Many market participants believed the Fed had significantly increased transparency and had been clearly communicating its objectives to the market. That feeling has now largely disappeared.
As such, when the Fed does announce the start of a taper, the nature of the message will be crucial in determining the direction of short-term correlations between equities and bonds.
According to Brian Jacobsen, portfolio strategist at Wells Fargo Asset Management: “Over the long term bonds will be a good hedge, but we may see them move in the same direction as equity in the short term, so they will not be a great diversifier. The catalyst will be the Fed announcing its plans to taper. If there is a gradual increase in yields, that could be positive for equity, but much depends on how the Fed communicates why it is starting the taper. If it says it is because of a sustained and substantial improvement in the labour market, that will be positive for equities. If it emphasises concerns about financial excess, it will be negative for equities.”
Barclays’ research shows normally positive correlations between interest rates and equities moving to near-zero levels on the back of short-term surprises in Fed policy. Over the longer term, once the uncertainty surrounding Fed policy lifts, it too expects the correlation to become more positive, albeit less than before due to the incrementally higher rates.
Can ‘normal’ resume?
Whether the correlation between bonds and equity will ever return to pre-crisis levels is also uncertain. In their efforts to stave off deflation, central banks have extended their balance sheets massively. Central banks will not be able to step away from manipulating markets any time soon as they have a genuine need to keep yields low and currencies weak. The likelihood is, therefore, that a period of rising equity markets as growth returns to the global economy is met with continued yield suppression, breaking the traditional correlation. The scale of debt suggests this could continue for some time yet.
“The non-correlation between bonds and equities is potentially permanently broken, at least for the next 10-to-20 years because of inflating central bank balance sheets,” explains Nick Buckmaster, chairman of the London Borough of Waltham Forest Council pension fund.
“Their sensitivity to inflation is impaired and that has to be because of the volume of securities central banks are holding. The demand/ supply mechanics are not what they were pre-2008.”
One of the most traditional methods to reduce this debt is to inflate it away, allowing the currency to depreciate and holding yields low. This raises two interesting questions, both of which will likely result in a degradation of the traditional negative correlation between equities and bonds.
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