This is a chart we’ve shown over, and over, and over again this year.
It shows the 10-year Treasury rate (red line) vs the S&P 500 (blue line) going back 5 years.
As you can see, for a long time, the red and blue lines moved together.
And there’s a logical reason for this. When stocks rally, people pull their money out of risk-free Treasuries, causing interest rates to rise. Stock rallies also indicated (theoretically) heightened growth and inflation expectations, which also puts upward pressure on rates.
And the same happens in the opposite scenario. Stock selling has been associated with lower rates, as people flock to risk free Treasuries.
So it’s been a matter of some head scratching that since late 2011, stocks have rallied sharply, while 10-year rates have had a difficult time holding a nostril above the 2% level.
Some blame the Fed for this. Language about holding rates low for a long time, and hints at a third QE theoretically depress long-term rates. One problem with this though is that we’ve already seen two QEs and a Twist, and that didn’t cause the divergence we’re seeing now, so this isn’t totally satisfactory.
Another explanation is that despite the improvement in prospects (which has been manifested in the stock market) there’s still just a lot of money out there looking for risk-free assets at a time when the potential pool of risk free assets is diminishing. Think: Europe. Everyone’s still looking for a safe haven, but the number of banks and governments seen as risk free has dropped dramatically in the last year. So everyone flocks to Treasuries.
Nomura’s rates guru George Goncalves thinks this phenomenon is coming to an end.
He wrote yesterday:
With the eurozone crisis likely to take a temporary hiatus, global investors will finally be able to breathe a sigh of relief and reduce their flight-to-quality (FTQ) hedges in USTs. We view the facts that there are no scheduled events in the eurozone or significant periphery bond supply in the coming weeks, as a catalyst that will re-focus US markets back to US fundamentals and Fed policy. We see scope for a move towards our Fed-adjusted fair-value of 2.40% on 10s based on our estimates that the Euro risk premium is worth nearly 50bp on 10yr yields. As European-based investor FTQ flows unwind, this should allow the US rates market to realign to the strong recent economic data.
We should note that Goncalves has been making some version of this call since close to the beginning of the year, but perhaps the completion of the latest Greek bailout without a hitch has finally reduced the need for such dramatic safe-haven inflows, and the great contradiction will finally reverse itself.