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Central bank moves keep stocks and bonds in synch

Source: Reuters - Fri 18th Sep 2009

Stocks and government bonds - which usually move in opposite directions - have both been rallying recently, prompting wariness that one of the two asset classes is poised for a swift change of direction.

However, the huge amount of liquidity injected by central banks and the steps taken to revive the world economy may have scope to keep driving both stocks and bonds higher until policymakers talk about reversing such policies.

Improving macroeconomic data over the past six months has fuelled hopes of a speedy recovery for the global economy and helped global stocks rise 66 percent since March.

While bond prices might have been expected to fall as investors took on more risk and ventured back into equity markets, central banks' policy stance has ensured the contrary.

Central banks' assurances that they will keep rates at very low levels for a while to ensure the world economy recovers from its worst economic crisis in decades have boosted demand for government bonds, while also underpinning stocks.

"Currently, there is a strong logic behind both the equities and the bond market rallies" said Philippe Waechter, head of economic research at Natixis Asset Management, in Paris.

"On the equities side, the broadly positive macro signals suggest that we will get upgrades in corporate forecasts, and this supports the rally. On the fixed income side, investors see that, among the Group of 20 (nations), nobody wants to end accommodative monetary policies any time soon."

That means that 10-year U.S. Treasury futures and the S&P 500 .SPX currently have a daily correlation of +0.4 on a rolling 25-day average. The correlation, which was -0.9 in early August, has been in positive territory since late last month. 


The massive sums of money injected by central banks into the system have also played their part.

"Both asset classes are benefiting from the slight improvement in the economic landscape, but also the high level of liquidity" said Philippe-Henri Burlisson, head of fixed income research at Groupama Asset Management.

"With all central banks' quantitative easing measures, every market player has liquidity to invest, and they don't want to end the year with big cash positions when comes the time to close the books, especially while the markets are rallying."

This has helped push the benchmark 10-year U.S. Treasury note yield to its lowest since mid-July, at 3.272 percent on Friday, down 62 basis points from a two-month high of 3.893 percent hit in early August.

The 10-year Bund yield is down 25 basis points from early August to 3.250 percent, close to its lowest levels since early May.

Government bonds' "resilience ... during the summer months in the face of strong economic data and rallying equity markets suggests that there is further upward potential in the event of a more pronounced setback on stocks or a loss of momentum in cyclical indicators," said Cyril Beuzit, global head of interest rate strategy at BNP Paribas CIB, in London.


Stocks may in fact be reaching a plateau after a rally from March lows that drove the S&P 500 .SPX up 57 percent and Europe's benchmark FTSEurofirst 300 up 54 percent. 

That rally has propelled stock valuations higher, with the average price-to-earnings ratio for the S&P 500 at 16.8, a level last seen since May 2008, and an average ratio of 13.4 for the FTSEurofirst 300, the index's highest level since July 2007.

This could signal that the economic recovery might now be priced in, making it difficult for stocks to rise on further positive macro news.

But although stocks look poised for a dip, or at least a pause, bonds also face headwinds of their own, though perhaps not in the short term.

Central banks' quantitative easing have created demand for bonds and kept yields low. But the vast injection of liquidity also risks fuelling future inflation - which would erode bond values. In any case, sooner or later, policymakers will have to pull the plug on these emergency measures - and risk triggering a sharp spike up in yields.

"The fact that both stocks and bonds have been rising hand-in-hand is an anomaly stemming from central banks' quantitative easing, because policymakers are keeping rates very low to kick-start the economy" said Jean-Claude Petit, head of equities at Barclays Wealth Managers France.

"In this context, the stock market rally has been natural, while the rise in bond prices is artificial."

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