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The bond/equity disconnect resolves in favor of equities

Last week I noted the significant disconnect between rising equity prices and very low and falling bond yields. Low bond yields are symptomatic of dismal economic growth expectations, but rising equity prices point to improving expectations. One explanation for this disconnect that I offered was that equities are not necessarily pointing to a strong economy, but rather to an economy that is now seen to be less weak than it appeared to be a month ago. Bond yields remained low, I suggested, because the outlook for the economy is still weak enough to warrant extremely low short-term interest rates for at least the next several years, much as the Fed has been telegraphing. 

This week the disconnect between the two markets seems to be resolving in favor of equities. 30-yr Treasury yields are up sharply—nearly 50 bps—in the past three weeks, with most of that rise occurring in the past 12 days. Meanwhile, 2-yr Treasury yields are up less than 10 bps, which suggests that the market has not made any major adjustments in its expectations for near-term Fed tightening. (2-yr Treasuries can be thought of as the market's expected average Fed funds rate over the next 2 years.) Most of the action in recent weeks has come at the long end of the curve—from 10 to 30 year—which is consistent with my theory that the outlook for the economy has become less dire, and so the risk of deflation has been reduced considerably (the bond market typically views a very weak economy as posing deflation risk). But the economy has not improved enough to warrant any major change in the outlook for Fed policy. I'll stick with my view that equities are rallying not because the economic outlook is becoming healthy, but rather because it is becoming less awful—don't forget the drumbeat of expectations calling for the economy to now be in recession. This is still a reluctant rally.

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