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Bonds And Equity Correlation
by Peter Cherry

No one knows how long this will last or how severe it
will be, but the prior disinflation cycle has now finished.
We have noted on numerous occasions that it is impossible
to have benign inflation forever and that economic cycles
will always move in and out of the ideal economic
environment. Johannesburg, South Africa ~ As equity markets
continue to power ahead, we have seen a weakening of US
Treasury bonds this week. Does the bond market know
something we don't and is this an important junction? The
long economic cycle we entered into in 2000 is one of
deflation, falling interest rates and rising unemployment.

The positive correlation seen in the past cycle between
equity and bonds will break down as we continue in a
primary bond bull market, whilst equities enter into a
primary bear market.

However, this week we have seen bond prices weaken in the
US as investors become nervous about stronger than expected
economic numbers. We have regularly pointed out that the
bond market is a better interpreter of economic information
than equity markets so what is going on? The 10 year yield
has risen from 3.07% to 3.36% and the long bond has also
weakened Materially from 4.17% to 4.40%. The inflation
adjusted 10 year note was at 1.54% earlier
in the week clearly showing the bond market is not
concerned about inflation but more the lack of it. However,
the stochastic for bonds has turned down, the 21-day rate
of change has turned down, so is this the beginning of the
end for bonds? The bond market has definitely become
nervous in the short term and newspapers claim that the
perception of only a 25bpts rate cut at the next FOMC
meeting instead of 50bpts, is the reason.

In the medium term, foreign banks, particularly from Asia,
continue to buy US Treasuries with their massive current
account surpluses and Greenspan continues to walk the lower
interest rate talk. Many commentators are forecasting a
bond market correction as we reach 40 year yield lows but
with such buying pressure and deflation still a major
concern, this is considered unlikely. Japanese 10 year
bonds still yield 0.5% today.

Declining bond prices means rising long rates, and rising
long rates to the mortgage business is a major problem.
Perhaps the bond market will rise in the short term
providing the catalyst required to correct the expensively
priced equity and property markets? Greenspan and the U.S
Fed are certainly trying to avoid such a scenario.

Finally, all the factors behind the past 12 month's
strength in Treasuries suggests there is little risk of a
major rise in yields unless there is a clear pick-up in
economic activity. In our view that's not likely and we
should see yields continue to trend down. As we are in a
primary bull market for bonds, short-term weakness becomes
a buying opportunity.

Members of the media are invited to visit
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