Suspection of Window Dressing?
The US Federal Reserve (FED) make history on Tuesday by cutting the target interest rate to between 0% and 0.25%. With that interest rate cut came the accompanying historical low yield for the benchmark US 10 Year Treasury Note which fell to 2.07% today.
Generally speaking, the US 10 Year Treasury Note yield has tracked the FED interest rate for the past 20 years. This is can be seen from the graph below which shows the performance of the MSCI World versus the US Treasury Yield and FED interest rate. Click on the graph for a clearer view.
However, the correlation seem to have disappeared starting around 2002 to the not too distant past. The interest rate were low relative to historical standards. A possible explanation for the vanishing correlation could be the popularity of Collateral Debt Obligations (CDO) due to the search of higher yield.
CDOs were first introduced in 1987 and quickly gained popularity. A valuation methodology which allowed the rapid pricing of CDOs was introduced in 2001. The thirst for higher yield can thus be met using CDOs which can now be priced rapidly.
As the financial tsunami swept through the world with the collapse of Lehman Brothers and the subsequent fallout of the CDO market, investors suddenly find themselves with nowhere to hide. All major asset classes have dropped in tandem, the only difference being the magnitude of fall. The only safe haven now seem to be in government bonds. As investors pile-in in the flight to quality and safety, the yield have dropped to record low levels.
The following graph illustrates the same comparison for the past year. As can be seen, there was a drop in the yield starting around November. On the hand, the MSCI World started to rebound around mid-November after the sell-off from the Lehman bankruptcy and AIG crisis. The MSCI World has managed to recover 20% from the low in mid-November. However, the US Treasury yields have continue to drop and have dropped 44% from starting of November or 29% from the corresponding low of the MSCI World index.
Why the drop in US Treasury yield while the market is ‘recovering’? It could be that the market is buying US Treasuries in anticipation of the FED rate cut. Or could there really be window dressing? Fund mangers are looking for protection in US Treasuries while pumping the market for a better looking portfolio during the year end. If there is a sell-down in the new year, the US Treasuries will offer protection to the downside.
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