Lawrence G. McMillan Get email alerts

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Published: July 1, 2010 12:01 a.m. ET


Commentary: Treasury bonds predict more economic malaise


LawrenceG. McMillan


MORRISTOWN, N.J. (MarketWatch) -- Options have many uses, but are primarily used as a hedge by a number of investors and traders to take some uncertainty out of the market. This is well-known to professional traders, but less so for the novice option trader or, even worse, the investor who doesn't use options because he considers them to be strictly a speculative vehicle.

In this article, we're going to discuss one kind of uncertainty: that of "risky" vs. "risk-averse" asset classes; the apparent dichotomy created in the economic outlook by bullish corporate earnings versus the broad economic backdrop of an economy that just can't seem to improve.

Another type of hedge for stock portfolios is the outright purchase of options on the S&P 500 SPDR SPY, +0.32% exchange-traded fund or the volatility index VIX, +0.90% For more on that strategy, read my recent column on macro protection for stock portfolios.

Risk vs. risk averse

In times of great financial distress, assets tend to separate into these two classes. In bear markets and/or when investors are worried about economic conditions, risk-averse assets dominate. But when investors are bullish and/or believe the media's and government's incessant claims that economic recovery is just around the corner, the risky assets dominate.

In the classic sense, risk-averse assets are U.S. government Treasury bonds and the U.S. dollar. In the current financial crisis that began in 2007, the Japanese yen is also in the risk-averse category.

Risk assets, on the other hand, are just about everything else -- primarily stocks and commodities not related to finance (copper, oil and agricultural commodities, for example).

One might not think that these things would move in common, and most of the time, they don't. But in times of financial crisis, they do, because investors have no interest in owning any of them, and they are all sold. Meanwhile, there is a flight to safety, as investors buy U.S. T-bonds and U.S. dollars.

This was never more evident than in the fall of 2008 and winter of 2009. Figures 1 through 4 show some of the uniformity of action in these various markets at that time. Figures 2 and 3 show T-bonds (continuous futures chart) and the U.S. dollar (March futures contract) rising (green trend lines) while Figure 1 shows the SPX declining (red trend lines).

The dollar's negative correlation to stocks was stronger than bond's, as bonds seemed to be influenced more by the pending passage of TARP and other stimulus measures at the time. The yen (not shown) rallied strongly from August 2008 to January 2009.

Figure 4 shows the iShares Goldman Sachs Commodity Index ETF (GSG) during the same time period. Obviously, commodities -- a "risk" asset -- were declining sharply during this same time period, as well.

Figures 1 through 4 also show that the period denoted by the trend lines was quite different, say, from the summer of 2008 (the left side of each chart) when these markets weren't very correlated at all. During the summer of 2008, stocks were falling (Figure 1) while commodities were still rising (Figure 4), while the dollar (Figure 3) and bonds (Figure 2) were relatively flat. That is, during the summer of 2008, the general consensus didn't recognize that such dire financial crises lay ahead, and thus there wasn't such a flight to safety, even though the stock market was declining during that summer (2008).

The correlation of these assets doesn't end there, though. Even as the stock market began to rally, in March 2009, the correlation persisted between these asset classes -- it just reversed. From March 2009 through July 2009, risk assets were in demand while risk-averse assets were not. I suppose one could offer opposing arguments as to what that means. The positive viewpoint would be that investors think the crisis has passed, and thus are moving into risk assets again. The more negative interpretation, though, would be that these assets shouldn't be so uniformly correlated in "normal" times -- and therefore, by inference, this would describe a market rally in a financial crisis, rather than a true economic recovery.

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