The correlation between markets & QE II……..

The markets have become more and more correlated with the risk-on/risk-off trade (interesting article about this topic in the FT yesterday - link here: http://www.ft.com/, but one thing has changed: the equity markets and the US in particular has been able to shrug off bad news while embracing the good news….

This in itself has happened before and in particular it reminds me of the mind-set from the autumn of 2007 where one CNBC market commentator phrased it something like “if we get bad economic data, the Fed will lower rates and that will be good for stocks….” I think he managed, in the same report to say that the stock market was a forward looking market…

So fast forward till the autumn of 2010 - treasuries are approaching all time low yields (some parts of the curve have already traded through the previous lows) because of disappointing economic data and the anticipation of QE II, while the stock market manages to rally albeit not to new highs on the same information. 

Warren Buffett is out again talking about how cheap the stock market is (and how expensive the bond market is) - personally he did that trade in October 2008 - His op-ed was published on 16th October 2008 in the New York Times so for a little fun experiment, I have compared the returns of a US treasury bond index and the S&P 500 from that date till yesterday’s close (7th October) and the results are surprising……...think about it purchase of US equities in the middle of a massive bear market compared to an index of US treasuries. Which performed better? 

Oct 2008 - Oct 2010:       S&P 500                   +22.36%

                                             Treasuries           +22.90%

So in my book they have had the same performance, but think about the difference in volatility and the asset classes - the “riskiest” vs the “safest” - I have put both in quotation marks as it’s not obvious that everyone agrees about the relative risk or safety of either, but at least traditionally that’s how they were perceived. Any money manager would, at least in hind-sight, have kept the treasuries.

The real point I am trying to make is that the current scenario where good news is good news and bad news is also good news (for equities) may come to an end - some members of the FOMC are making their views known that QE II is not a foregone conclusion and any reasonable participant should question the fact that the QE I in large part has just ended up in excess reserves - so why would more of the same work better?

The markets most at risk are perversely, in my view, not treasuries, but gold and equities, which have been rallying on the back of QE II leading to inflation, while treasuries are rallying on a basis of QE II coming, or not, not leading to inflation - all three cannot continue to rally together!