Thursday, 11 June 2009

Beta arbitrage strategies running into Treasury yield "issues"

The two primary (and inter-related) themes that I am currently focused on in the US markets are the big moves upwards in yields at the long end of the Treasury spectrum - to be followed soon by equally big moves at the shorter end as suggested here - and the relative out-performance of the small cap stocks against those in the S&P 500.

Since the March lows the best way to understand the price action in US equities, I would suggest, has been one where macro asset allocators, and quant funds, have been using high frequency and complex arbitrage strategies designed to be relatively risk neutral but with an overall tilt towards helping the US equity market to rebuild its confidence by being long the high beta performers (Russell 2000 index) and short the lower beta stocks (S&P 500).

This type of action is entirely consistent with the overall theme of demonstrating to the mainstream fund managers that it is safe to step exposure to stocks as there is, according to the agenda, a new bull market emerging - indeed it resembles similar the trading activity that was seen during the 2004-6 period.

The unfortunate piece of the puzzle is shown by the rather shocking under-performance, from the perspective of price, of US Ten Year notes - as indicated by the very sharp back up in yields reflected on the relative performance chart above. After a poorly received ten year auction yesterday the yield has effectively doubled since the historic low yields, within a whisker of two percent, seen at the end of 2008.

Beta arbitrage algorithms have certainly succeeded in giving an overall lift to equity prices and in turn improving confidence and sentiment, but the chart should act as a sober reminder that - given the magnitude of the US Treasury's borrowing requirements - the tried and true formula of pumping up prices to create a compelling environment for broader participation in equities may have more surprises to contend with this time around.

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