Something to keep everyone happy – Bond markets and equity markets outperforming

The month of August was an investor’s dream, with major asset classes like equities, government bonds, corporate bonds and property producing positive returns over the month. However, like two gunslingers in the American Old West, the equity and government bond markets are now currently staring each other down waiting for the other to flinch.

Taking the UK as an example, 10 year gilt yields and the FTSE All-Share Index are normally correlated, ie when the equity market goes up, gilt yields also go up and vice versa. As the chart on the left shows, up until the end of July this rough guide held true.

More recently, this relationship has broken down. And for our readers outside the UK, the relationship between equity returns and government bond yields has also broken down in Europe and in the US. The talking point in markets over recent weeks is the fact that equity markets have continued to rise while at the same time gilt yields have fallen. This has occurred very rarely in the past 5 years, so why is it happening now?

Part of the answer lies with the Bank of England’s Quantitative Easing programme. Bank of England Deputy Governor Charlie Bean has recently told markets that without the programme gilt yields would be around 50-75bp higher. And as the chart shows, a direct read of where gilt yields are relative to equity markets suggests the same.

Looking ahead, I’d expect that the usual relationship between gilt yields and equity market returns will reassert itself. But does this occur because equity markets fall or because gilt yields rise? That’s the interesting question here. In my view, the Bank of England will have to think long and hard about its QE exit strategy. Gilt yields are sure to rise if the Bank stops buying and the UK Debt Management Office keeps issuing.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Discuss Article

  1. JMcD says:

    Good comment, and I've been wondering the same about this.  QE might recently be an element, but I'm not convinced it is the cause.  Share prices need a strong economy to support their value, and gilts have been the best proxy to indicate UK economic strength.  As confidence in UK plc income increases the decoupling of gilts and equities will return.

    Question for myself today, is will there be an October equity correction?  If so, then hanging onto my gilts for another month is a good call.  If not: ho hum.

    Would like to ask if a different graph can be used next time.  This compares to distinctly different terms.  One is a capital value and the other an income stream, it would be far easier to read if the asset price was used in both cases.  More so as investors usually have just one of these as an objective, i.e. capital growth, or income stream.  Maybe the correlation looks stronger with the comparison you provide, but I'm doing mental cartwheels trying to keep up.

    Posted on: 09/09/09 | 12:00 am
  2. Clive says:

    As a simple bondholder (via M&G Corporate & Strategic Bonds), rather than a "real" financial-type, I'd like to ask what is probably a really dumb question about QE.

    Having "invented" £ NN billions to fund purchase of Gilts and Corporate Bonds, how will the BoE unwind from that when QE is no longer deemed necessary.

    Will they simply hold the Gilts & Bonds to maturity, then (literally) shred the money they collect ?

    (As they "printed" it in the first place, increasing money supply by £ NN billions, shredding £ NN billions at maturity puts the money supply back where it was before QE)

    Posted on: 09/09/09 | 12:00 am
  3. Anthony Doyle says:

    The most likely exit strategy will be for the Bank of England to finish the asset purchase scheme gradually and eventually start hiking the base rate.  Then, if it needs to turn the taps hard, it could then sell gilts back to the market, which would have the effect of pushing gilt yields up, reducing the money supply, and slowing economic growth and inflation.  If inflationary pressures fail to materialise and growth remains weak for a prolonged period, then as you suggest, the BoE could just let the gilts that it holds mature, and shred the cash. 

    Ben Bernanke delivered a very interesting speech to the London School of Economics earlier this year. In it he addresses "Credit Easing versus Quantitative Easing" and "Exit Strategy". The speech is well worth a read click on this link.

    Posted on: 16/09/09 | 12:00 am

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