Fixed-Income Yields Flash "Buy" Signal for Equities

How can investors tell if it is the right time to buy equities by studying the bond yields?

Global market suffered a severe slump in January 2008. The Hang Seng Index dropped by 21.8% year-to-date as at 22January 2008. Singapore’s FSTE STI index fell by 17.3% during the same period. Despite all the volatility going on, we think that it is important for us to look at what has happened so far and if equity markets remain attractive versus fixed income markets. Would any indicators from the fixed income market signal overselling in the equity markets?

Inflow of Money into Bonds

Global markets underwent a severe correction due to the concern of a recession in the US. Money flowed from equities to fixed-income markets. Chart 1 shows the US Treasury Yield Curve. This curve is constructed by six different maturity yield points – 3 month, 6 month, 2 years, 5 years, 10 years and 30 years. As shown in the chart, the curve shifted downwards from 9 January 2008 to 23 January 2008; hence, the bond prices increased. However, the yield dropped less than the Fed rate cut of 75 basis points on 22 January 2008. Table 1 shows the change in bond yield and prices. As shown in table 1, the 10-year Treasury price went up by 305 basis points within this short period. What does the sudden drop in yield signal for investors?

Chart 1: US Yield Curve

Source: Bloomberg

Table 1: US Treasury Yield

Maturity	Yield		Price		% Change
	09-Jan-08	23-Jan-08	09-Jan-08	23-Jan-08
3M	3.23%	2.32%	99.20122	99.42114	0.22%
6M	3.25%	2.35%	98.4079	98.83722	0.44%
2Y	2.71%	2.01%	101	102.3438	1.33%
5Y	3.13%	2.58%	102.25	104.8125	2.51%
10Y	3.81%	3.44%	103.5313	106.6875	3.05%
30Y	4.34%	4.20%	110.875	113.4375	2.31%

Source: Bloomberg and Fundsupermart.com Compilations

Bonds Are Overbought!

We believe bond yields are hitting the lowest level, signaling that bonds are overbought. Chart 2 shows the yield difference between the 2-Year Treasury and the Fed rate. Since 1990, there were only a few periods where we saw a negative number for the spread between the US 2-year Treasury yield and the Federal Reserve target rate. On 22 January 2008, after the sudden rate cut of 75 basis points (bps), the negative difference in spread narrowed from -209 basis points to -149 basis points, which means that the Federal Reserve overnight target rate is now 149 basis points higher than that of the 2-year Treasury bond yield. This would seem technically illogical because an investor is getting a much better yield (of 149 basis points) from depositing monies in overnight treasury bills than the 2-year short-term US fixed-income bond. Thus, we think that this may signal overbuying in short-term bonds and overselling in equity markets. In fact, we are starting to see signs of the negative spread narrowing.

We think that the negative spread would narrow and eventually normalise to a spread of above zero basis points. From chart 2, you can easily spot that for most of the time, the spread was above zero. Thus, in time to come, there is a strong likelihood that the spread will converge. But how would this happen?

There are two ways that the spread will converge –it is either the Fed cuts rates by another 150 bps to 2%, or the demand for US treasury bonds decline and money flows out from bond investments. When the demand for bonds declines, bond prices would go down and inversely, bond yields will be higher.

We think the first scenario of a 150 bps rate cut to ‘normalize’ spreads is not likely to happen in the very short-term. Particularly since the FOMC has just cut rates by 75 bps on 22 January - the largest single rate cut since 1984. However, it could be a possibility in the next one to two years if the FOMC really wishes to spur spending by using this expansionary monetary policy.

Thus, we think that the latter scenario is more likely to happen. If investors start to become less risk averse, it would mean that demand for bonds would decline; yields would then rise. When that happens, spreads would gradually normalize. Given that negative spreads is not something we usually see, it is likely that once investors regain confidence in the equity markets, money would tend to flow out of fixed income and move into equities.

Chart 2: 2-year Treasury Yield Significantly Higher Than the Fed Rate

Source: Bloomberg and Fundsupermart.com Compilations

Buying Opportunities For Equities

What does the narrowing of negative spreads mean to our investors? Judging from the spread in the bond markets, we think that it signals overbuying of fixed income, which in turn means buying opportunities for equities.

From Table 2, the 2008 Estimated PE for most of the Asian markets is attractive after the severe market correction. In addition, earnings growth remains strong for 2008 and 2009. From a 3-year investment time horizon point of view, it is definitely a good time to buy into Asia ex-Japan equities. Investors could take a look at our article: ‘ Asian Equity Markets on Sale!’ to find out more about our view on which markets look particularly attractive now.

Table 2: Attractive Valuation and Strong Earnings Growth (as at 22 January 2008)

Market	Estimated PE for 2008	Estimated PE for 2009	Growth Yr 08 (%)	Growth Yr 09 (%)
MSCI Asia ex Japan	14	12.6	15.9	11.5
Singapore	12.5	10.9	11.3	15.0
Hong Kong	14.4	12.4	12.6	16.4
Taiwan	13.9	13	17.7	6.5
Korea	10.6	9.7	17.6	8.5
China (HSMLCI)*	16.4	14.4	20.2	14.1
Malaysia	15.1	13.7	13.5	10.9
Thailand	7.8	7.3	21.8	7.2

Source: Bloomberg and Fundsupermart.com Compilations

Conclusion

Market volatility is increasing as we see more economic indicators pointing to a recession in the US. Even if the recession is short-lived, it would impact market sentiment, particularly that in the US. However, we believe the Asia ex-Japan region will continue with its growth. Developing Asia is slated to grow 8.3% in 2008, according to estimates from the International Monetary Fund. Furthermore, it has attractive valuations and healthy earnings growth levels. The Asia ex-Japan region’s earnings is forecast to grow at strong rates of 15.9% in 2008 and 11.5% in 2009, propelled by continued domestic spending, investments and intra-Asian trade. Hence, we are optimistic over the performance of Asia ex-Japan equities in the coming two to three years.

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Eddy Wong (Analyst & Financial Adviser Representative) is part of the Research and Editorial team at Fundsupermart.com, a division of iFAST Financial Pte Ltd.