Here’s What The Changing Stocks-Bonds Correlation Means For Equities When The Fed Tapers

The chart below shows how the correlation between U.S. Treasury yields and  the Dow Jones Industrial Average has varied under each iteration of the  quantitative easing program of bond purchases the Federal Reserve has employed  since the financial crisis. Under QE3 (the current iteration), changes in bond yields have have been  associated with larger changes in equity prices than under any other program.  So, when yields rise, so do equities, and when yields fall, so do equities — in  both directions moreso than in the past. The red square near the top of the chart plots the current levels of the  yield on the 10-year Treasury note and the DJIA. Its place above the regression  line shows that equities are looking rich based on this relationship.


Bond yields-equity prices regression

Société Générale fixed income strategists believe the regression line is  actually too steep. In other words, when yields rise again (induced by a tapering of QE) as they  did earlier this summer, the strategists believe the relationship charted by the  regression line will break down as higher yields fail to boost equity  prices.

“We have currently reached a new peak in equities, and the  ‘beta’ — that is, the strength of the relationship for equity prices to rise as bond yields rise (the  coefficient on ‘x’ in the regression equation) — is probably unsustainably high as the Fed tapers asset purchases over the next six months,” write the SocGen  strategists in a note to clients.

“Based on the QE3 regression equation, the projected level of the Dow for a 10-year Treasury yield at 3.00% is 15,916; for 3.25%  it’s 16,338; and for a 10-year Treasury yield at 3.50%, the Dow  would be at 16,760, or 5% higher than it is right now. We don’t  expect equity prices to dive, but we do suspect that in 2014 as the Fed eventually tapers asset purchases, the level of bond  yields will rise and equity prices will be volatile, moving roughly sideways for a time while both markets re-adjust.”

This is not necessarily an uncommon view on the Street. JPMorgan chief U.S. equity strategist Tom Lee, who claims the highest year-end S&P 500 price target of any  strategist at a major bank — cites tapering as his chief concern. “The biggest risk to our thesis, in our view, remains the potential for a negative monetary policy surprise (more likely in the U.S. than Europe),” he  says. “That is, we believe equities remain uncomfortable with the notion of  asset tapering without the economy at perceived escape velocity.”



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