One of the main drivers of emotion in the sharemarket in recent times has been the US Federal Reserve Board's Quantative Easing (QE) program. Fed chairman Ben Bernanke has used QE to, in effect, print money by buying US government bonds back from big investors and pumping cash into the economy.
In theory, QE should have resulted in the banks lending more of their bulging cash reserves to business and a revival in the US economy. However, much of it seems to have found its way into the sharemarket, driving it toward record levels.
As this week's chart, produced by Alan Clement, a member of the Australian Technical Analysts Association shows, the QE program has been so big it has changed the normal relationship between shares and bonds. As US Treasury bonds are considered a safe bet, investors tend to park their cash there when the sharemarket is falling, pushing bond prices higher (and interest rates lower).
Conversely, when investors are bullish on shares they sell out of bonds and move into equities, pushing the sharemarket higher and bond prices lower. Bonds and stocks are therefore said to share an inverse correlation, with their respective lows and highs corresponding.
The vertical, light green lines on the chart demonstrate this inverse relationship. They highlight periods when shares have been high, bond prices low, and vice versa. Remember that bond yields on the secondary market are determined by what investors are prepared to pay for a bond.
If the price of a $100 bond paying 10 per cent is bid up to $200 then the effective interest rate is halved to 5 per cent. The Fed's QE program pushed so much money into shares during much of 2011 and 2012 that the inverse relationship no longer worked and divergence appeared.
The sharemarket rose as money flowed out of bonds but the Fed's bond-buying was strong enough to push the price of bonds up at the same time. The divergence began to ease late in 2012 and bond prices slid after Bernanke said QE would taper off as the economy recovered. The tapering has not yet started, but expectations are driving markets back to their habitual relationship.
Looking at recent price action, Clement says it seems that bonds have been oversold and we could see price retracement in the near term. However, the bond market trend is still down and any recovery could be short-lived. Indeed, there is evidence to suggest that bonds have been at multi-decade highs.
Bond prices may fall for years to come, with interest rates rising. US share prices, however, have run up steeply and are meeting some resistance, but long term the trend is still up for the S&P 500 and the inverse relationship between stocks and bonds looks set to continue, Clement says.
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