Equities are not the only asset class rallying

What lies behind the sudden surge in US Treasuries prices?

There has been an increase in coverage of the rally in bond markets recently -- specifically the US bond market and how it relates to equity markets.

We thought it was timely to offer a few explanations as to what is happening and what it might mean for equity markets.

Firstly, we need to understand that US Treasuries (bonds) are typically viewed as the ultimate safe haven. When the world gets nervous, money flows into US Treasuries. Secondly, as bond prices rise, the yield on the bond falls. There is an inverse relationship.

Since the GFC, US and European central banks have been conducting Quantitative Easing (QE) programs to stimulate their economies. This has been implemented via the bond market, where the central banks have been purchasing bonds and driving interest rates lower.

The best known QE case is the US Federal Reserve Bank which was purchasing US$85 billion of bonds per month up until the beginning of 2014. This lowered interest rates to a level that stimulated the recovery we are seeing in the US economy today.

Since the much talked about “tapering” began, the US Federal Reserve has reduced its monthly bond purchases from US$85bn to its current pace of US$45bn per month.

As demonstrated in the chart below of the US 10-year bond yield, US bonds fell and interest rates rose in 2013 as markets anticipated a slowdown in purchases. However, this has reversed with a vengeance this year.

Graph for Equities are not the only asset class rallying

Source: Bloomberg

Here are a few of the theories behind this reversal;

1) Probably the biggest factor has been the deterioration in the euro zone economy. This has led to expectations that the European Central Bank will almost certainly cut official interest rates to try and boost the flailing recovery. On a relative basis, the fall in European interest rates makes those available in the US relatively more attractive. This creates buying demand for US bonds, which in turn sends US interest rates lower.

2) This surge in bond prices has been exacerbated by large short bond positions. A short position is created when participants are looking to benefit from falling prices. The market was expecting bonds to fall hard and interest rates to rise as the US Federal Reserve Bank reduced its monthly bond purchases. This would also translate into strength in the US dollar as rising interest rates increased the attractiveness of holding US dollars.

It was these expectations of a collapse in US bond prices that saw large short positions develop. It was a very crowded trade. When deterioration in Europe triggered a flood of demand for US bonds, those participants betting on a fall in bond prices quickly found themselves in a precarious position. This resulted in a stampede for the exit door, adding fuel to the fire and triggering a jump in US bond prices.

On top of the above reasons, there is also strong demand for US bonds from Japanese pension and life funds as Japanese rates are significantly lower than in the US.

We can see how these reasons have combined to trigger a sharp move higher in US bonds. Normally, a sharp rally in US bonds is caused by a “flight to safety” as investors move into perceived safe havens from risker assets like equities.

This doesn’t look to be the case this time around and is likely to have less of an impact on equity markets.

Ben Potter is the Retail Editor at Baillieu Holst