No Consensus on Where Bonds Will Go

Two weeks ago, we addressed the potential effects of quantitative easing on the stock market. Last week we were concerned with the gold rally. Now we'll tie both issues together and sprinkle in two other targets of quantitative easing: bonds and the dollar. Although these four asset classes sometimes move together, they generally have minds of their own.

Only one full cycle of quantitative easing has finished. The second will end in June. So there is really too little data to make predictions. As I learned from my statistics professor, it's not a good idea to base conclusions on a "series of fewer than two observations."

Nevertheless, many predict the end of phase two of quantitative easing (QE2) will simultaneously end the big stock market rally. Some also say -- logically, I think -- that Treasury bonds will fall with the stock market when the Federal Reserve stops buying them. No less a pundit than Pimco's Bill Gross, manager of the world's largest bond portfolio, agrees. Gross announced he's now shorting Treasury bonds.

However, his concern is not universal. Some bond managers expect the opposite result and provide convincing evidence to support their views. I've plotted the important quantitative easing events below against charts of the S&P 500 and the yield of the 10-year Treasury bond. (Keep in mind that when bonds drop in value, their yields increase.)

The first vertical line (gray) represents the start of QE1 on Nov. 25, 2008. The S&P was in a free fall, which may have slowed in anticipation of the $600 billion about to flood the market as the Fed geared up to buy Treasury bonds.

The process began on Jan. 1, 2009 (first green line), but the market continued to fall until an additional $1.125 trillion was added to the pot three months later (second green line). Then the market started the long rally that still persists.

However, note that the first important correction started soon after QE1 ended in March 2010 (red line). It continued until Fed Chairman Ben Bernanke hinted in a speech at Jackson Hole (second gray line) that QE2 -- a program for the purchase of an additional $600 billion in Treasuries -- would begin in November (third green line).

Now that we know QE2 will end in late June, many anticipate a market correction, similar to the one last summer. But what can we expect bonds to do?

The blue plot at the bottom of the chart represents the yield of the 10-year Treasury bond. When QE1 started, the yield plunged from 4% to 2%. In less than a month, bonds jumped higher in anticipation of Fed buying. Should we expect the opposite when QE2 ends next month, just as Gross expects?

Well, the reason some portfolio managers expect bonds to move higher and yields to fall next month is because that's what happened when QE1 ended (red line). Yields had crept up to about 4%. Instead of moving higher when the Fed stopped buying bonds, it fell to 2.4% and stayed there until QE2 began.

What happened is clear from the chart, but the mechanism is less apparent. Yields may have dropped because of reduced fear of inflation. Inflation is the thing bond investors fear most, because it robs the value of their bonds by returning dollars that are worth less.

Quantitative easing is inflationary. So when the Fed stops buying bonds, the rate of inflation may slow. That would allow interest rates to move back to the lower part of their range. Gross doesn't believe this will happen. But some of his competitors plan to buy Treasuries when the Fed stops buying them. We'll soon know who is right.

In summary, the stock market advanced during easing and fell when it stopped, while bonds did the opposite. This forced yields higher, in the same direction as stocks, which is unusual.

The effects of quantitative easing on gold and the dollar are more difficult to analyze. Gold has climbed for the entire period while the dollar has been mostly lower. As you can see in the next chart, in spite of its 2.5-year decline, the dollar has had three recovery periods: two at the start of QE1 and QE2, and one spurt last April and May after QE1 ended.

Logically, we should expect the dollar to weaken while the Fed prints them. But there is insufficient evidence to suggest that it wouldn't have fallen anyway, for general economic reasons. So there is no guarantee that it will rally when the Fed stops the presses next month.

My guess is for a bounce, but it's nothing more than a guess. And if the dollar does bounce, logic suggests weakness in gold, even though that was not the case last year when gold just kept going up. Once again, we'll have to wait and see. If we're smart, we'll watch closely.

— Fred Goodman, a registered investment advisor and Certified Financial Planner, publishes MarketMonograph, a daily, Web-based subscription service specializing in technical stock market analysis and the application of economic indicators to market timing. You can reach him at fred@marketmonograph.com.