"Something Is Wrong": Deutsche Bank Spots an Odd Market Divergence

By Tyler Durden  /  ZeroHedge

One of the closest correlations between major asset classes has been that between stocks and bonds. But not anymore, because as Deutsche Bank’s chief international economist notes in a Wednesday note, the historical relationship between stocks and bonds is breaking apart, prompting Slok to exclaim that “something is wrong“, as it could portend danger for those investors holding Treasurys in the hope these would cushion the slide in stocks.

it is no secret that bond prices and stocks are inversely correlated, or at least have been in normal times, but all that changed this year as Treasury prices have largely failed to reflect the slump in stocks, as MarketWatch notes.

“What is safe to say is that there is something driving equities lower, which is not impacting rates. Or there is something keeping long rates high, which is not impacting equities,” Slok wrote in a Wednesday note.

This correlation breakdown has undercut the bond market’s status as a safe haven in a year in which few asset classes have eked out positive returns. This correlation “failure” was on full display yesterday when despite the record point surge in the Dow, Treasury yields posted a very modest move higher (one which has since been faded on Thursday). And, as MW notes, if traditional havens like U.S. government paper struggle to shield portfolios from a further selloff in equities it could mean investors will lack few reliable boltholes going forward.

To show this regime shift, Slok charts the movement of the 10-year Treasury yield against percentage changes in the S&P 500 over the last five years. It shows the two correlating closely until 2018, when they split.

Another indication of the failure of bonds to keep up with stocks: the S&P 500 is down 8% YTD, while the 10-year note yield is up more than 30 bps to 2.77% leaving the bond market also nursing negative returns this year. As a result, investors with a balanced portfolio of stocks and bonds (usually in a 60/40 ratio) have been saddled with unexpectedly deep losses, which have also hit such “balanced” entities as risk-parity funds.

What is behind this odd divergence?

According to Slok, the uncharacteristic weakness in bonds may have taken hold after bond traders began to see a gradual increase in auction sizes after Trump signed off on tax cuts, bringing the reality of trillion-dollar deficits much closer and a surge in bond supply in coming years. That may have pushed bond yields higher this year, when they should have fallen along with equities if their classic relationship had held up.

“What happened in January 2018 was that the corporate tax cut had to be financed by a significant increase in Treasury supply, and maybe the reason why long rates remain so high is because the market is beginning to price a U.S. fiscal premium into U.S. government bonds,” said Slok.

Furthermore, according to Slok anyone expecting this divergence to collapse shortly may be disappointed since the breakdown of the positive correlation between stocks and bond yields may not just be a temporary problem as the federal government is projected to notch annual trillion dollar deficits for a “very long time,” said Slok, prompting traders to demand even higher bond yields in the future regardless if stocks underperform.

https://www.zerohedge.com/news/2018-12-27/something-wrong-deutsche-bank-spots-odd-market-divergence

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