Wednesday, January 18, 2012

The divergence of treasury yields and equity prices

Typically treasury yields and "risk assets" such as equities move in tandem because the "risk-on" trade is based on the anticipation of improved economic activity. However recently we've had a material divergence between the two, in particular with equities. The chart below compares the S&P500 index with the 10-year treasury yield.

S&P500 vs. 10-year treasury yield (Bloomberg)

There are numerous theories for this effect floating around.  Here are some of them.

1. Operation twist.
2. Dollar strength lifts both equities and treasuries.
3. Mutual fund flows into both equities AND fixed income.
4. Slow growth in the US is consistent with corporate profitability growth.
5. Anticipation of QE3 (which is clearly not going to happen).

None of these however seem satisfactory in explaining this effect.
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