One cycle that continues to drive the markets is the “risk-on, risk-off” cycle. And as we’ve seen in recent months, the Fed is in the driver’s seat.
With the continuation of its long-standing zero interest rate policy, you’d think the Fed wouldn’t be able to move the market much. Yet market participants now hang on every word that leaves Bernanke’s mouth, parsing each syllable in search of clues and hidden meanings.
The main question on everyone’s mind is: when will the Fed take away the punch bowl?
In early May, the market, true to its forward-looking nature, began to signal the collective fear that the Fed would soon stop the music. Take a look at this chart, showing both the volatility index, or VIX (in white), and 10-year Treasury rates (in green)…
Normally, these two move in opposite directions.
When skepticism and fear mounts, the VIX tends to shoot higher, while Treasury yields drop lower as investors begin buying bonds for their perceived safety.
Likewise, when investors are optimistic and greedy, the VIX falls while Treasury yields climb as investors dump T-bonds in favor of riskier assets.
Yet, in early May, these two markets moved up in tandem. The rising VIX indicated investors had shifted from a stance of complacency to one of caution. Rising Treasury yields showed investors were selling, not buying, U.S. Treasury bonds.
I suspect the rise in T-bond yields can be largely attributed to the market’s fear that the Fed might suddenly stop buying bonds as part of its stimulus efforts. As the Fed has been the driving force behind lower yields, and higher bond prices, investors didn’t want to get stuck holding the bag when the Fed pulled out.
And, true to the Fed’s form, Bernanke has now issued a mixed message…
In May, his comments were interpreted as hawkish… sending stocks lower, while the VIX and Treasury yields shot higher.
Then, just yesterday, he struck a more dovish tone saying, basically, “the punch bowl isn’t going anywhere, anytime soon.”
Naturally, Treasury bond prices jumped while the VIX drifted lower.
Watch for this trend – declining volatility and Treasury yields – to continue as long as Bernanke doesn’t suddenly change his tune again.
And of course, this is all welcome news for stocks. New highs appear to be on the horizon.
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