TRADING GOVT. SECURITIES USING THE SENSEX; EQUITIES LEAD BONDS BY 7-MONTHS

POSITIVE RELATIONSHIP BETWEEN S&P 500 RETURNS AND 10-YEAR U.S. TREASURY YIELD CHANGES

There is a well known positive relationship between U.S. Treasury yields and the S&P 500 returns. There are two interpretations of this covariance. First, risk appetite is pro-cyclical. Likelihood of a strong economy results in allocation in favor of equities versus treasuries. Second, stocks discount the profit outlook that lies ahead and bonds the likely Fed actions. A recession implies earnings downgrades and Fed cuts. An upswing in aggregate demand has the opposite consequences.

10-year U.S. Treasury Yield = -0.41 + 0.88* S&P 500

Data: Monthly percentage changes - July 1990 to December 2008
R^2 = 2%
t-statistic (beta) = 2.02

NEGATIVE RELATIONSHIP BETWEEN SENSEX RETURNS AND 10-YEAR INDIAN GOVERNMENT SECURITY YIELDS

To test the relationship for India, I ran the following regressions:

MONTHLY DATA

10-year GOISEC Yield = -0.02 - 0.75* SENSEX

Data: Monthly percentage changes - January 2000 to December 2007.
R^2 = 10%
t-statistic (beta) = -3.03

10-year GOISEC Yield = -0.26 - 0.41* SENSEX

Data: Monthly percentage changes - November 1998 to December 2008.
R^2 = 2%
t-statistic (beta) = -1.79

DAILY DATA

10-year GOISEC Yield = -0.003 - 0.27* SENSEX

Data: Daily percentage changes – July 2002 to January 2009.
R^2 = 1%
t-statistic (beta) = -4.40

I experimented with different periodicity and time periods just to be sure of the robustness of the results. The message is clear. Contrary to economic logic, an inverse relationship exists between Indian government bond yield changes and equity returns.

THE MARKET THAT GETS IT RIGHT CAN BE USED TO TRADE THE ONE THAT GETS IT WRONG

In my view, the reason behind this counter-intuitive relationship is that different players dominate the landscape in stocks and bonds. Foreign institutional investors determine the rhythm of the SENSEX. Nationalized banks rule the roost in the government securities world.

Based on the above, it seems likely to me that equities get the economic outlook more correct on average. Firstly, international investors have much better access to research and have a keener eye on the global cycle. Secondly, there is the big question of incentives. FIIs are paid to get things right and have to face the music for wrong bets. That is certainly not the case at nationalized banks where there is only downside for assuming risk.

SENSEX GETS IT RIGHT ON AVERAGE

Empirical evidence supports my hypothesis. RBI’s research suggests (Business Cycles and Leading Indicators of Industrial Activity in India, RBI Occasional Papers (2003)) that the SENSEX leads industrial production by about 12-months.

BOND YIELDS LAG EQUITY RETURNS BY ABOUT 7-MONTHS

I ran simple regressions using various monthly lags for stock market fluctuations. The fit parameters work out best for the 7th month.

10-year GOISEC Yield = -0.83 + 0.16* SENSEX (-7)

Data: Monthly percentage changes - November 1998 to December 2008.
R^2 = 8%
t-statistic (beta) = 3.23

LAST YEAR WENT BY THE BOOK; WHAT ABOUT 2009

Given my assessment of the Indian economic cycle, I would not sell government securities with yields at current levels. I get the same message from equities. Issues related to the transmission mechanism of monetary policy can be sorted out only over long periods. For now, the RBI needs to respond with the tools at hand. The only thing that the Reserve Bank can do is to reduce base rates, flood the system with liquidity and hope that deposit/lending rates respond in due course.

Bloomberg is the source for all data.