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December has brought a major change to the financial markets, although it’s largely gone unnoticed. For the first time since June, the stock and bond markets have become decoupled. In other words, stocks are going up while long-term bonds are going down.

Yesterday, the yield on the thirty-year Treasury bond (^TYX) broke 4.8% for the first time in seven weeks. Despite this, the S&P 500 (^GSPC) has continued to rally, and it now stands just shy of a six-year high.

This is important because the bond market often acts as an early warning sign for the stock market. Decoupling usually precedes bad news for stocks. For example, stocks and bonds became negatively correlated beginning on April 25, shortly before the May 5 top. The negative correlation lasted until June 15, which was two days after the S&P 500’s low for the year. It’s as if the two asset groups were competing against each for investors’ money, and the bond market was winning.

But all that changed on June 16. From there until late-November, stocks and bonds (BTTRX is my bond proxy) had an amazing 79% correlation. Basically, the two asset classes stopped fighting with each other and marched higher arm-in-arm. It was a nice, smooth rally.

The truce finally came to an end. Since November 30, stocks and bonds have had a 60% negative correlation. This is a brief period, so it may not mean much, but something is definitely up. I don't think the stock market is about to collapse, but we've had a 16% rally since June. It may be time for a breather.

Posted by edelfenbein at December 29, 2006 8:36 AM