Divergences in Equity and Fixed-Income Markets

As we discussed recently, divergences and anomalies can happen in financial markets, and this is exactly what is happening right now

Divergence Between Credit Default Swap and Equity Volatility

Yesterday, Tom Lee pointed out some diverging signs in the stock market:

First, Lee is concerned that the long-term yield curve has narrowed substantially. A flattening yield curve is a widely viewed marker of slowing economic growth, as this suggests the expected return of long-term spending then has smaller expected return on investment. The spread between the 30-year Treasury yields and the 10-year Treasury yields, as Lee observed, has flattened since just after the U.S. election in November “and historically signals market weakness ahead.”

“In the past, the bond market has been much better at ferreting out problems and smelling slowdowns; that’s the message from the yield curve. So I think the bond market is really taking the position that growth is going to disappoint, and the gap between the hard data and the soft data is still pretty big,” Lee said Monday. 

10 year Treasury June future. Source: Interactivebrokers

Next, he outlined that the credit spreads of high-yield debts started widening

Specifically, Lee notes that since 1998, the market has seen 30 instances in which high-yield spreads widened 60 basis points, as it did in late March, and the market saw a decline in 93 percent of instances (falling by a median 4 percent). The thinking is that high-yield indicates a tightening of financial conditions. Read more

As we discussed earlier, under normal market condition, a low-volatility equity market should be accompanied by low credit spreads.

On the same topic, Sid Verma reported on Bloomberg that there are disparities between the stock and bond markets.

In the green corner are stocks. The Standard & Poor’s 500 index is just 0.2 percent away from a record high reached in March on bets that Donald Trump’s administration will push through tax-code changes to spark growth. In the red corner sit U.S. government bonds, where benchmark 10-year Treasury yields have unwound almost half of their post-election increase, suggesting a far more pessimistic view the economy.

“The increasing divergence between global equity market performance and bond markets has raised questions as to whom is right,” Jefferies Group LLC analysts led by Sean Darby wrote in a note. Read more

How long will these divergences last and what would be the final outcome?
This is the question that everybody wants an answer.