Monday, December 26, 2011

Have yields stopped listening to economic releases? ......

I came across this very interesting graph this morning. In normal times and circumstances (whatever that may mean), bond yields are heavily influenced by how weak or strong the economies prospects are perceived to be. In the graph, the white line is the Citi economic surprise index, which is an index that shows the deviation of actual economic releases in comparison to the expectations. Clearly, the index has had a very strong move up in the latter half of the year, as US economic releases have generally been stronger than expectations. In the past, the yield (the 10 year - orange in the graph) would have moved up in tandem, as a better than perceived economy would have led to a movement from the fixed income market (lower prices higher yield) into the equity market.
But times are far from normal. Markets are absolutely terrified of PIIGS defaults. Thus despite stronger news emanating from the US, the awful news out of Europe has seen the Treasuries retain an unprecedented demand for the "perceived" safe haven status.

Surely though in unveiling Operation Twist, whereby the Fed is aggressively buying long dated bonds (to keep the yields low) and selling shorter dated bonds, that has been the determinant in keeping lower yields? I'm not so sure. If for some reason, somehow, the market became convinced that Europe was turning the corner, and that there was light at the end of the tunnel, wouldn't the yields be expected to rocket higher, Fed or no Fed?

Yields are at all time lows- yields are pricing in the risk that the market may not exist in a recognisable form in the not too distant future, with fears of defaults and a collapse of the financial system.

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