The chart below shows how the correlation between U.S. Treasury yields and the Dow Jones Industrial Average has varied under each iteration of the quantitative easing program of bond purchases the Federal Reserve has employed since the financial crisis.
Under QE3 (the current iteration), changes in bond yields have have been associated with larger changes in equity prices than under any other program. So, when yields rise, so do equities, and when yields fall, so do equities — in both directions moreso than in the past.
The red square near the top of the chart plots the current levels of the yield on the 10-year Treasury note and the DJIA. Its place above the regression line shows that equities are looking rich based on this relationship.
Société Générale fixed income strategists believe the regression line is actually too steep.
In other words, when yields rise again (induced by a tapering of QE) as they did earlier this summer, the strategists believe the relationship charted by the regression line will break down as higher yields fail to boost equity prices.
“We have currently reached a new peak in equities, and the ‘beta’ — that is, the strength of the relationship for equity prices to rise as bond yields rise (the coefficient on ‘x’ in the regression equation) — is probably unsustainably high as the Fed tapers asset purchases over the next six months,” write the SocGen strategists in a note to clients.
“Based on the QE3 regression equation, the projected level of the Dow for a 10-year Treasury yield at 3.00% is 15,916; for 3.25% it’s 16,338; and for a 10-year Treasury yield at 3.50%, the Dow would be at 16,760, or 5% higher than it is right now. We don’t expect equity prices to dive, but we do suspect that in 2014 as the Fed eventually tapers asset purchases, the level of bond yields will rise and equity prices will be volatile, moving roughly sideways for a time while both markets re-adjust.”
This is not necessarily an uncommon view on the Street.
JPMorgan chief U.S. equity strategist Tom Lee, who claims the highest year-end S&P 500 price target of any strategist at a major bank — cites tapering as his chief concern.
“The biggest risk to our thesis, in our view, remains the potential for a negative monetary policy surprise (more likely in the U.S. than Europe),” he says. “That is, we believe equities remain uncomfortable with the notion of asset tapering without the economy at perceived escape velocity.”