Deutsche Bank

A disconnect has formed between the S&P 500's performance and the 10-year yield, according to a note from Deutsche Bank's chief international economist.

"US long rates are too high or S&P 500 is too low," Torsten Sløk said, illustrating his point with a chart of the S&P 500's year-over-year change and the 10-year Treasury yield.

The two have diverged sharply since the start of this year, leading Sløk to believe the disconnect has come as a result of the Treasury market pricing in the corporate tax cut — while the stock market has not.

The relationship between the US stock and bond markets has broken down, according to a new Deutsche Bank analysis that underscores uneven fundamentals between the two.

The US 10-year Treasury yield has diverged sharply from the S&P 500's year-over-year change, leading Torsten Sløk, the firm's chief international economist, to contend that either the stock market is too low or that long-term rates are too high. Either way, he said, "Something is wrong."

"What is safe to say is that there is something driving equities lower, which is not impacting rates," Sløk added. "Or there is something keeping long rates high, which is not impacting equities."

The S&P 500 has plunged more than 12% over the last year, as shown in the chart above, while the yield on the 10-year Treasury note has dropped as sharply. At 2.749%, the note's yield is down from its 2018 peak of 3.248% in October, but up from 2.405%, where it began the year.

The disconnect, which appears to show that the stock market is reacting to information the Treasury market is not, could be the result of algorithms and "momentum traders," who execute trades based on price trends, Sløk added.

"But this explanation is puzzling because Treasuries would normally be the safe parking spot for computers worried about a downturn."

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More likely, he wrote, is that President Donald Trump's tax-reform package, specifically the tax cut for US corporations, has been priced into the Treasury market but not into the stock market.

"What happened in January 2018 was that the corporate tax cut had to be financed by a significant increase in Treasury supply, and maybe the reason why long rates remain so high is because the market is beginning to price a US fiscal premium into US government bonds," Sløk said.

"If this is the case then the rates and equity correlation will remain broken because we will have US government budget trillion dollar deficits for a very long time."

Still, other market watchers say the stimulus from the tax-reform package has already begun to fade, particularly as trade war-related uncertainties and interest-rate increases have taken center stage.

"In the US, the double dose of caffeine from tax cuts and spending increases is already starting to wear off," Bank of America Merrill Lynch economists Ethan Harris and Aditya Bhave told clients last month.

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