A Gap Is Emerging That Shows Why The Bond Market Could Get Crushed

One of the most striking illustrations we've seen so far of the recent rally in stocks and risky assets comes courtesy of Deutsche Bank rates strategists Francis Yared and Dominic Konstam.

Lately, stocks have staged a big upward move as perceptions of tail risks in the market have diminished and investors have turned bullish on economic growth prospects.

This has Wall Street buzzing about the "Great Rotation," a big shift out of bonds and into stocks that is becoming widely expected sometime in 2013.

But bond yields still haven't really gone anywhere, and a lot of bond market participants are worried about what will happen when they finally do.

A repeat of the "1994 moment" – when there was a total bloodbath in the bond market as yields screamed higher – is weighing heavily on many minds right now.

To read more about what happened in 1994, click here >

On to the chart, then, which can be understood thus: The USD 5s30s slope refers to the spread between yields on 30-year bonds and 5-year bonds. The spread should rise in response to a "risk-on" move as investors move out of long-term bonds and yields on those bonds go higher.

For their part, Yared and Konstam don't necessarily think a "1994 scenario" in which the bond market crashes is in the cards.

In a note to clients, the strategists write:

The market dynamics seems to be driven by an excessive focus on the benefits of central bank liquidity and reduced tail risk combined with a relative skepticism about the growth outlook. For instance, core curves appear dislocated relative to equities.

...

The question therefore is whether this divergence (the new abnormal) can persist for much longer. In our view, the market is probably placing too much emphasis on future central banks’ support and not enough on growth. If this is indeed the case, then some of the gap between core real rates and risky assets will need to close. Given our constructive view on the growth outlook, we would expect core rates to converge towards risky assets rather than the other way around.

On the other hand, Morgan Stanley analyst Huw Van Steenis was just in Davos for the World Economic Forum last week, and he said every single investor he talked to was concerned about the same thing: a repeat of 1994.

SEE ALSO: The '1994 Moment' Is Keeping More And More Bond Traders Awake At Night >