Is the Bond Selloff for Real? Watch These Sectors for a Clue

by Daniel Putnam | May 30, 2013 1:25 pm

Is the Bond Selloff for Real? Watch These Sectors for a Clue

Bond investors might not be thinking about China’s growth outlook right now, but they should be.

Based on the performance of the market segments most sensitive to economic trends in China — coal and steel stocks, industrial metals, and Chinese stocks — the recent rise in bond yields could turn out to be a head fake.

Here’s why: In the past three years, China-sensitive investments have exhibited a high correlation with U.S. Treasury yields. When investors are feeling good about global growth, yields rise and these four market segments rally; when investors aren’t feeling good, yields fall.

However, the spike in Treasury yields — from 1.63% on May 2 to 2.12% on May 29 — hasn’t been accompanied by a corresponding rise in the four asset categories mentioned above. Are Treasuries providing a false signal, or are these other investments destined to play catchup?

Correlation Breakdown

To get a better grasp of the answer, it helps to look at recent history. In the past three years, the four ETFs representing market segments closely tied to China have exhibited very high correlations with Treasury yields. While their returns certainly have varied in magnitude, they have largely moved in similar directions.

Below is a correlation table that shows just how closely these areas of the market — as represented by Market Vectors-Coal ETF (KOL[1]), Market Vectors Steel Index Fund (SLX[2]), PowerShares DB Base Metals Fund (DBB[3]), and iShares FTSE China 25 Index Fund (FXI[4]) — have tracked the 10-year Treasury yield during the past three years. Keep in mind, correlation runs on a scale from -1 (perfectly inverse) to 1 (perfectly correlated), so all four of these numbers show just how tight the relationship has been:

CorrelationTable1a Is the Bond Selloff for Real? Watch These Sectors for a Clue [5]

In contrast, the correlations of these same ETFs with the 10-year yield have been mostly negative since May 2. The result can be seen in the table below:

CorrelationTable2a Is the Bond Selloff for Real? Watch These Sectors for a Clue [6]

Which Market Is Right?

At first, this shift seems to make sense given recent economic developments. Even as renewed fears of a “hard landing”[7] in China have regained steam, the outlook for the United States continues to improve. This was highlighted by Tuesday’s economic reports, which featured housing and consumer confidence that came in above expectations.

In reality, however, the key factor in the divergence is likely the prospect of Fed “tampering,” which has distorted the bond market’s usefulness as a gauge of economic expectations in recent days. As a result, securities such as DBB and FXI might be painting a more accurate picture of current conditions.

The bond market can continue to move independently from investments related to global growth for a few more days, or perhaps even weeks, but the correlation has been so strong in recent years that it’s reasonable to expect a reversion to their longer-term pattern. This could take the form of either lower Treasury yields or a recovery in the China-sensitive sectors.

For now, the most likely outcome is that bonds will settle down — and begin to reflect the global economic picture more accurately — once investors become used to the Fed’s new approach. On the other hand, if China and industrial commodity-related areas do indeed begin to rebound in June while the 10-year yields holds near 2%, that would represent an important confirmation that the jump in Treasury yields is in fact a sustainable development.

Keep a close eye on this relationship in the coming weeks to gain a sense of what’s next for bonds.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Endnotes:
  1. KOL: http://studio-5.financialcontent.com/investplace/quote?Symbol=KOL
  2. SLX: http://studio-5.financialcontent.com/investplace/quote?Symbol=SLX
  3. DBB: http://studio-5.financialcontent.com/investplace/quote?Symbol=DBB
  4. FXI: http://studio-5.financialcontent.com/investplace/quote?Symbol=FXI
  5. [Image]: http://investorplace.com/wp-content/uploads/2013/05/CorrelationTable1a.jpg
  6. [Image]: http://investorplace.com/wp-content/uploads/2013/05/CorrelationTable2a.jpg
  7. “hard landing”: http://slant.investorplace.com/2013/05/china-pmi-hints-again-at-hard-landing/

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