Tandem Performance Puzzle

Typically, stocks and bonds go in opposite directions, a tendency that has exhibited itself throughout most of 2009. But in the last four weeks, long-dated Treasuries have risen right alongside equities, as the pair has each notched a 6% gain.

I believe there are two reasons for this sudden correlation. First off, hedge fund managers have spent a good chunk of the year building trades that profit from a steepening of the yield curve, which consists of a long position in short-dated bonds while selling-short longer-duration paper. This strategy, which profits as 30-year yields rise and shorter maturities fall, assumes that inflation will increase as the economic recovery takes hold.

Thanks to a prolonged slump in retail sales, concerns over deflation (lower prices due to reduced aggregate demand) have trumped the logic of this position, resulting in a massive unwind of the steepening trade. This has resulted in a bond rally that has also served to reduce 30-year mortgage rates below 5%, the first time for this to occur since May, when many analysts thought those levels would not be seen again in this economic cycle.

We also believe that market participants are hedging their bets in the stock market by beefing up their fixed-income exposure. The big run-up in the S&P 500 index has created a need for rebalancing among many large asset allocators, and the recent strength in bonds is certainly reflecting this buying interest. These factors will likely support bonds for the balance of the year.

Ben Warwick (ben@qesinvest.com) is chief investment officer of Quantitative Equity Strategies LLC in Denver, and Memphis-based Sovereign Wealth Management, Inc.

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