On July 31, the future contract on the 30-year Treasury experienced an unusual volatility and an anomalous high trading volume for a non-rollover day. The trading range reached 3.78 percent, one of the widest in the history of the contract. Had the S&P 500 experienced such a historical day (with a daily trading range of, let us say, 10 percent), all newspapers would have been full of comments about the issue. This was not the case for the mentioned bonds noteworthiness, although this anomaly could be particularly interesting as the combination of high daily volumes and volatility usually signals a short-term reversal.
While the equity market has been trading sideways for two months, the bond market has been very active. Yields rocketed upward in response to the strong FED policy statement to keep the economy going and avoid the deflation specter at any costs. The bonds market interpreted it as the beginning of a new phase in which the main issue to deal with will be fighting inflation.
This is clearly visible by the immediate adjustment of inflation expectations derived from US inflation-linked Treasuries, which trade actually slightly below the current inflation figures.
Happy holders of the Rydex series Juno fund! The fund is an open-ended fund incorporated in the USA. The fund’s objective is to provide total returns that will inversely correlate to the price movement of the Long US Treasury. For this purpose it enters into short sales, futures and options transactions and is suitable for few investors. Consequently the fund’s net asset value (NAV) increased nicely during the recent sharp rise in the yield of the 30 year US Treasury. Since its launch in 19995, the fund’s total assets have been rising and amount now (7/25/09) to $634.5 millions.
A glance at the US yield curve shows that it has become very steep. The difference between the yield of the 10 and the 2 years Treasuries (term spread) has reached a level of 270 basis points. A steep yield curve is usually a sign that the economy regains strength.
In addition to improving macroeconomic figures, the widening of the gap between the long and the short maturities was driven by inflation concerns, and by the worrying refinancing needs of the US Treasury, which will total approximately $60 billion. The prolonged period of bad news for the bond market pushed up long maturities yields, with losses of around 10-15 percent.
Although the long term yields trend is rather up than down, we think that in the short term the fast rise in yields should stop. From a fundamental point of view, if yields rise too much to fast (meaning faster than the economy improves), they will slow down capital expenditure, mortgage and refinancing activities and eventually jeopardize GDP growth.
The recent rise in yields also affects the stock market, as the widened yield difference between bonds and dividend paying stocks reduces the relative attractiveness of stocks. This prevents yields form rising too much.
In order to assess market conditions the FED applies a model, which is based on the relationship between bond yields and the stock market price/earnings ratio (P/E). The equilibrium between the bond and the equity market is given when the yield of the 10-year treasury equals the reciprocal value of the P/E of the S&P 500. Applying the model in the current environment (with yields at 4.35 percent), the P/E of the S&P 500 should equal 23x. Or looking at it in another way, given the current P/E of 17.1x, yields should be at 5.85 percent! Interestingly, taking the 30-year Treasury for the sake of calculation, you will find out that the equilibrium P/E is at 18.9x, 10 percent from current value.
(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability or completeness of the information)