Submitted by Gavekal [5]via Advisor Perspectives [6],
Last week we wrote that the bond market is following perfectly the reduction of QE with new 1-year lows [5] and with today's bond moves that trend is still firmly in place.
In what may seem counter intuitive, treasury bond yields have had a high positive correlation with the rate of Federal Reserve asset purchases. When the rate of Fed asset purchases rises, bond yields rise, and vice versa. If one thinks of Fed asset purchases as stimulative to growth and inflation expectations (the two components that make up risk-free bond yields) then this positive relationship makes sense.
In the charts below we measure the rate of Fed asset accumulation by measuring the three month difference in the size of the Fed's balance sheet. Since the Fed has scripted out the end of QE, we can easily model out how this rate of change will proceed for the remainder of the year.
We then compare the rate of change in Fed assets to the 30-year bond
[7]
the 10-year bond... 1.5% by year-end
[8]
and junk spreads inverted
[9]
The link between Fed asset accumulation and these various bond yields is unmistakable, especially for longer duration bonds, and this simple model shows how even lower bond yields may be in the offing as the Fed puts on the breaks. For junk bonds, this seems to portend higher spreads, which may help to put the recent widening of spreads in context.
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So - tapering is tightening on risk assets...
