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.
