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VIDEOLink Between Chinese Stocks, US Treasuries Is Temporary
This short-term phenomenon is related to a policy already on its way out as China allows greater yuan revaluation.
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What do we do, then, when two previously disconnected markets start acting like one another? A recent research note suggested 10-year Treasury yields were starting to act like the Shanghai Composite index, and on the surface this is indisputable. Both Chinese stocks and long-term US Treasury yields, two markets whose fundamental connections we explored back in February, have declined in 2010.
However, US investors don't see the Shanghai index in yuan and as the dollar value of each basis point lower in yield increases, we need to compare the two total return streams in US dollar terms. In addition, we should use as much data as we can on a daily basis, which in this case means January 1999 for the MSCI-Barra China Free index. Treasuries are measured by the total return on the Merrill Lynch 7-10 year index.
The visual impulse now becomes one of rejection: What correlation? Even if we start shifting the series back and forth in time, we can't see anything of note prior to the mid-2009 point, when Chinese stocks were moving straight up and US bonds were declining in price.
If we run a few numbers to take our lying eyes out of the equation as much as we can, the answer doesn't emerge. A rolling three-month correlation of daily returns is inconsistent; moreover, neither the positive nor the negative values are very significant. The fundamental argument applicable since mid-2009, that Chinese stocks were suffering relative to US Treasuries as the People's Republic was shipping the people's money to Uncle Sam to finance the People's Stimulus Extravaganza and Clambake and, not coincidentally, to tighten domestic credit and simultaneously maintain the yuan peg, may have applied recently but certainly wasn't a factor during the last prolonged period of negative correlation, 2002-2003.
Let’s recall the principle a relationship must hold at all times and in all market conditions unless there's a sound fundamental reason for the exception. In this instance, we have to conclude the observed correlation between US Treasury yields and Chinese stocks is a short-term phenomenon related to a policy already on its way out as China allows greater yuan revaluation.
A good test when you encounter some obvious correlation emerging in the short term is to ask yourself, “What would I have though X years ago?” If the answer is you wouldn't have given the relationship a second thought, then chances are you shouldn't give it a second thought today.
There does seem to be one minor consolation prize, though: The current negative correlation of returns means US Treasuries and Chinese stocks do provide diversification when held together in a portfolio.
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