The Risk Parity Trade
1 Aug 2020 ● 10:31 AM
The US 5 year bond yield has continued to decline. For months it looks like an ending diagonal formation, but the yield was not hitting the lower end, nor breaking out on the upside. Wave E may be closer to completion if this chart is right, as yields finally did fall in wave E to the lower trendline of the pattern. I will need to watch for an actual price reversal to know that the pattern is complete. Its completion can mean a bottom in US bond yields despite the bond buying by the FED. As the dollar continues to fall it makes sense for yields to rise. Reason being that rising commodity prices at some point become inflationary and yields follow. We are not there yet as we are still coming out from the depths of a deflationary wave that preceded it. The initial bump up in yields will only be the first sign of this change.
What might be more significant is the impact a change in the direction of bond yields will have on perception of the crisis. The long term relationship between bonds and equities has been an inverse correlation. When bonds fall stocks rise and vice versa. This has to do with the perception of risk on or risk off. In a risk on environment bonds fall [yields rise] and stocks rise. So a reversal in the bond market in terms of yields could be beneficial to stocks. Many market analysts will perceive that as a change in market dynamics. It signals that investors have become fearless of the economy or credit and shifts asset allocation in favor of stocks and other risk assets. The chart of the bonds and equities below show how the recent rising bond market has slowed down the equities rally. A reversal down in bond prices could have a positive impact.