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Trader Desk Thoughts:
Treasury/S&P/Usd Market Correlation Test
TheLFB recently ran an article, which revealed the correlation between crude oil and the S&P futures had broken down, even though the two had shared a high correlation since the current rally started back in March.
In that article an interesting observation showed itself that Treasury and the equity markets did not share the same correlation, even though the other assets classes, like commodities, currencies, equities and corporate debt had done.
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TheLFB Charting. Click to enlarge
The above chart the correlation between the 10-year Treasury note and the S&P 500 index over the last two year of trading, starting from October 2007.
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TheLFB Charting. Click to enlarge
The second chart shows how the two moved in opposite direction over the last two and a half months, as S&P futures were making new highs, at the same time that the 10-year Treasury market was moving mostly lower.
Investors use the Treasury market as a tool to protect assets in times of uncertainty. Treasury yields moving lower means that institutional money is ignoring the 60% rally seen in the equity markets, but instead remain invest in the Treasury market for a 3.30% annualized yield on a ten year commitment, or much less if they choose shorter-term maturity yields.
Three scenarios can explain the resilience of the Treasury yield to rise.
The first is that the Fed is preparing to cut interest rates and investors are locking in yields at the current rate. The second is that the Fed is expected to join the Treasury market and drain the offer side of the market, thereby making current yields attractive. The third is that investors are in a phase of strong uncertainty that the equity markets can hold higher in the run-up to the Mutual Fund year-end book balancing that hits on October 31st.
However, with the Fed Funds Rate at zero to 0.25%, and unable to go any lower, and with the Fed determined to halt its Treasury buying program (quantative easing) sooner rather than later, the first two suppositions become rather questionable. The third one, intimating that investors are in a phase of strong uncertainty can be dismissed by the 60% rally seen in the equity markets, which is among the strongest in the history. It seems hard to have a 60% rally in 6 months and still claim that investors are uncertain.
Therefore, a big question remains as to what has caused the de-correlation between Treasuries and equities; are Treasuries underpriced or equities overpriced? Whichever market makes the next major break of resistance, either S&P long through 1080 or 10-year Treasury yields through 3.0%, will have a major impact on Usd dollar sentiment.
Until then we have confirmation of yet another market that is losing its twelve-month correlation to fair value on risk. This may be a massive swing point in global market direction, and one that sets the tone for where things may be at the end of 2009. TheLFB trade team will stay glued to these changes, and post to members the tradable action that comes from the next moves.
Building a trading plan around these moves, and learning how to control expectancy and cap exposure are covered in TheLFB on-line Training Academy Courses.