BofA Merrill Lynch US High Yield Effective Yield© FRED St Louis Fed

I’m confused because it does not seem to me that there is a single Ms. Market out there…

I used to strongly believe that bond and equity markets were tightly coupled by well-defined assessments of risk and a well-specified risk tolerance: take the risk-free rate, and to that the riskiness of a security times the premium per unit of risk, and you got the rate for that security. And as the risk-free rate moved up and down the whole configuration would move up and down, with some widening of spreads as the risk-free rate moved up and contraction as the risk-free rate moved down, but all in a predictable, stable configuration.

Thus safe bond and risky bond and stock prices would move in opposite directions in response to shocks to productivity and profits, and would move together in response to shocks to monetary policy and financial conditions.

Yet that does not seem to be true anymore. Since 2008 the ability of markets to actually make the risk transformation in sufficient volume that is needed for it to make sense to say “the market has a well-specified risk tolerance” seems to have broken down.

Safe bonds to their thing.

Risky bonds do their thing.

Short bonds do their thing.

Long bonds do their thing.

Equities do their thing.

And the spreads between them look like residuals more than relationships. Rather than trade ironing out the market into a single aggregate view, there seem to be three often inconsistent views here…