Exclusive to MrTopStep: Veteran bond trader and MrTopStep educator Jack Broz introduced us recently to one of his firm’s quantitative advisors, economist Dr. Michael Williams. Dr. Williams has specialized in studying monetary policy as it affects the interest rate markets, Treasury bond and note yields, and their effect on other markets such as equities. This research paper is the rare academic study which is as relevant to traders and analysts as it is to economic scholars. It is the culmination of years of research and analysis and Dr. Williams has generously made it available in pre-publication form exclusively to our readers.
In the paper, which you can view and download in its entirety, Dr. Williams makes the following predictions about the impact of quantitative easing (and its inevitable tapering) on the Treasury markets and on the Treasury/equity cross-asset relationship:
- Treasury yields will likely increase across the entire maturity spectrum with short-term yields increasing (absolutely and relative to longer-term rates)
- Equity prices will likely decline significantly
- Recent cross-market relationships between the US equity and Treasury markets will likely revert to pre-stimulus state, thus eroding cross-asset diversification benefits.
Before reaching those conclusions, Williams reveals several insights, some of them unexpected:
- US Fed policy suppressed Treasury yields across the entire yield curve (…however…)
- Lower-maturity yields were far more suppressed than longer-term yields
- Equity prices were likely inflated due to the Fed’s policies
- Equity/Treasury price correlations became markedly negative after QE began
Williams’ conclusion is stark and timely. From the viewpoint of someone looking at Treasury markets and then quantifying how changes in Treasury yields affect stock values, he finds that the S&P 500 as a whole is overvalued by more than a third. That big a divergence from fair value, and from being properly reflective of what quantitative easing is doing on the bond side, can mean only one thing: We are due for a major correction to the downside.
I asked Dr. Williams for his advice to traders and he said:
Traders wishing to prepare for the full effect of Fed “tapering” should be mindful of future lower bond prices, heightened bond price volatility, and lower diversification benefits from bond/equity portfolios.
To quote his report:
As can be seen, the S&P 500 Index was not greatly impacted by changes in the Fed Funds rate early on in the sample. However, a great upside divergence is seen after the beginning of the QE programs where the actual S&P 500 Index is far above and beyond what the index “would have been” without the stimulus. For example, as of 6/14/2013, the S&P 500 Index was 1,626.73 while the filtered Index was about 1,077.97. Based on an econometric model robust to sampling window and model-specification, the S&P 500 Index is estimated to be around 33.7% overvalued.
Below you can view and download the full report, posted on Slideshare.net. Thanks once again to Jack Broz for bringing this report to our attention.