Monday, February 26, 2007

Treasury Bonds and Market Correlations

Most investors occasionally need reminding that most markets move in the same direction in times of stress. Asset allocation and diversification is based on the idea of markets moving in different directions, for example, Japanese stocks rising while the US stock market drops or visa-versa. This was more the case in the 1970's and earlier; it is less true in the last several decades. Yet most asset allocation models are based on long time series that include pre-1980 data. Today's WSJ discusses Friday's rally in Treasury bond prices, "pushed higher by continued worries in the subprime-mortgage sector . . . after a benchmark credit-derivative index for risky mortgage loans hit record levels in the midmorning." John Spinello, Treasurys strategist at Jefferies & Co. followed by saying, "the subprime-mortgage market led the way with respect to a flight to quality," and Carl Lantz, fixed income strategist at Credit Suisse Group said that the weakness in subprime mortgages is starting to "leak into higher-rated credits."

What all this means is that the primary beneficiary during times of stress is US Treasury notes. After dropping 5 basis points on Friday, the 10-year treasury index interest rate is down another 5 basis points today to 4.63%. It has now retraced more than 50% of the rise from early December to late January. Looking back at extreme stress in the markets, such as October 1987, 1997, and 1998, treasury yields declined in each of those periods. We continue to feel that market developments favor a continued rally in quality fixed income, even while lower quality fades.


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