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The S&P 500 rose about 30 basis points on December 3rd, but today was a volatility-dispersion day, with the S&P 500 dispersion index rising. Not by much, but enough to highlight the dynamic of the index rising while implied correlations fell. We also saw index-level volatility decline, with the VIX down on the day, even as the VIX S&P 500 Constituent Index moved higher.
 

On the surface, it looked like a healthy rotation, with the MAG-7 lagging and the S&P 500 equal-weight index outperforming. But in reality, it was a day of MAG-7 underperformance and market participants trying to figure out how to nudge the overall index higher, amid bullish option flows beneath the surface.
 

According to the CBOE’s VIX decomposition tool, almost 2/3 of the VIX decline was due to the S&P 500 moving higher on the volatility curve, with the balance coming from volatility selling.
 

(CBOE)

Despite the weak ADP report this morning, the 10-year Treasury rate fell only about three basis points and remains above 4%. It’s an interesting dynamic because rates have essentially been holding around 4% on the 10-year, which appears to be functioning as a floor. This likely comes down to the fact that the overall yield curve is still not steep enough. The spread between the 10-year and the 3-month Treasury bill is only about 34 basis points, and historically, this spread peaks around 350 basis points.

So even if the Fed eventually cuts rates back to the neutral level near 3%, the 10-year would have little incentive to fall further—because the spread would still only be around 1%. In theory, if the 10-year were to trade at a historically normal premium of 300 to 350 basis points above the 3-month Treasury, then the 10-year yield should be closer to 6% than 4%.
 

This likely explains why long-end rates aren’t falling as many expect. The market seems to be acknowledging that the yield curve is too flat, and that the Fed is unlikely to cut deeply enough to create the kind of spread widening needed to normalize the curve. In a sense, the market is signaling that the curve needs to steepen further, and that process may begin as we get closer to the Fed’s ultimate policy destination and the market gains greater clarity.

It’s interesting because, at the same time, we’re seeing interest-rate spreads between the U.S. 10-year and the Japanese 10-year contract to their tightest level since March 2022, yet the Japanese yen has weakened to 155. The divergence between the spread and the currency is now one of the widest we’ve seen in some time, and it points to one of two — or potentially three — possibilities.

First, the yen may need to strengthen materially against the dollar, potentially even falling below 140.

Second, the FX market may be indicating that the spread is unlikely to contract any further — meaning U.S. rates may need to rise again, widening the differential.
 

And third, Japan’s rates would have to collapse. But with the BOJ preparing to hike rates because Japan still has an inflation problem and fiscal stimulus increasing, it seems unlikely that Japanese rates are about to fall sharply.

That effectively narrows the scenario set to just two outcomes: either the yen strengthens significantly or U.S. rates move higher.

Given that the U.S. Treasury yield curve is also signaling that it is too narrow and needs to steepen further—most likely through higher long-end rates—it seems more likely than not that the divergence between the interest-rate differential and the Japanese yen reflects expectations for U.S. rates to rise. In other words, the FX market may be betting that U.S. yields still have further to climb, which would help reconcile why the yen has weakened even as the rate spread has compressed.

It’s something worth thinking about.

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