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Stocks likely to rally before central banks stop hiking rates, says analyst

by Wayne Cheveldayoff, 2006-07-20

When do you think the current stock-market correction will be over and stocks will begin rising again in a sustained way?

If you think that will happen when North American central banks stop raising interest rates, you’ll probably be wrong, according to UBS Investment Research Strategist George Vasic.

In a recent report entitled “Equities: Watch bond yields, not Fed Funds,” the Toronto-based analyst says that based on what happened in two similar mid-cycle market corrections in the past, the stock market is likely to start its rally before the Federal Reserve and the Bank of Canada are finished raising interest rates.

His report also points to declining bond yields as being the trigger for a stock-market rally.

“The real key to a sustainable equity rally is declining bond yields. In…the mid-cycle pauses in 1994-95 and 1984-85…lower bond yields (which have not yet occurred this time) triggered an equity bounce months before the Fed paused,” he states, noting that the Canadian experience was broadly the same as the U.S. experience.

“What triggered the bond yield decline? In both cases, it was significantly slower economic growth, and not reduced inflation, which seems to be the market’s current obsession.

“The slower growth was sufficient to allay concerns about future inflation, paving the way for lower bond yields to provide a valuation boost to equities – the Fed only stopped raising rates after the fact.

“The implications for the present are twofold. First, growth will need to slow much more than is expected to trigger a significant bond-yield decline – until then, uncertainty will likely linger despite Federal Reserve rhetoric.

“Second, the potential equity rebound looks to be less than the previous two because the decline in bond yields is likely to be much less and the earnings cycle is more advanced this time.”

The report notes that in the 1984-85 cycle, the trigger for the rise in the S&P 500 was the decline in U.S. 10-year Treasury bond yield, which had already declined 1.12 percentage points before the Federal Reserve-controlled Fed Funds rate (one-day interest rate on cash reserves traded between banks) peaked three-months later.

“Notably, the S&P 500 rose 10.7 per cent in that period, and then rose another 26.8 per cent in the following year while the U.S. 10-year yield dropped another 3.79 percentage point.”

The 1994-95 episode was not as pronounced, and therefore more closely resembles the current situation, but the mechanisms were the same, the report states.

“Once again, much slower growth allayed inflation concerns (with the core consumer price index remaining stable at about 3 per cent), leading to a 0.69 percentage point decline in the 10-year yield and a 7.4 per cent rise in the S&P 500 before the Federal Reserve’s last move.”

Since the summer of 2004, the U.S. Federal Reserve has raised the Fed Funds rate from 1 per cent to 5.25 per cent. The U.S. 10-year bond yield has moved along a gyrating path from less than 4 per cent to a recent 5.25 per cent.

At the time of the writing of the UBS report (July 5, 2006), the U.S. 10-year bond yield had not yet started a sustained decline and published statistics were still not clearly showing an economic slowdown.

The same picture prevailed for Canada. The Government of Canada 10-year bond yield at 4.40 per cent was tending more to creep higher than lower and the economy was still looking to be in rapid-growth mode.

Overall, using Mr. Vasic’s analysis, it didn’t look like it was the right time for investors to commit more funds to the stock market. Also, seasonal and technical analysis tools were suggesting a stock-market low was more likely to happen in the August-October period.

Is now the right time to be buying stocks? Mr. Vasic would say, “Check the 10-year bond yield.”

That information can be obtained from financial sections of newspapers that carry bond tables or at such Internet sites as or

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at and he can be contacted at

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©2006 Wayne Cheveldayoff