-- Mark Twain
Quite the environment we find ourselves in, no?
First, Fed Chair Janet Yellen comes out and shocks the short end of the Treasury curve with comments regarding interest rate hikes. Then, minutes show that the Fed was concerned with the market's interpretation of stimulus going forward. Emerging markets apparently don't care either way, while high-beta areas in the US break down meaningfully. Utilities all along have been screaming caution. As outlined in a Dow Award-winnig paper I co-authored, "An Intermarket Approach to Beta Rotation," when the utility sector leads the market, going back to 1926, the environment tends to favor high volatility and potential corrections. We appear to be behaviorally in the midst of that now.
For my firm, our ATAC (Accelerated Time and Capital) models used for managing our mutual funds and separate accounts are playing defense. From an absolute-return perspective, this means long duration Treasuries. From a relative sector-return standpoint, this means positioning into Health Care, Utilities, and Consumer Staples (i.e. low-beta areas). While everyone is beginning to wonder what exactly is going on in biotech, the real question everyone should be asking is what is going on with the yield curve. Long-duration Treasuries simply should not be this strong. Why are they outperforming so much with the Fed stepping back from bond buying?
There are a few explanations that are plausible here. The first is that the market is replacing the Fed. Deflationary pressures remain real, and as the Fed steps away from the bond market, money from stocks is ironically replacing support from the Fed. The second possible scenario is that the Fed may actually not taper next month. I believe this is a distinct possibility. The best way for the Fed to counter the hawkish impression investors may have now is to prove that it can slow down or stop quantitative easing. This might be why long-duration bonds are strengthening as the implication is continued buying to come.
Regardless of the reason, bonds are laughing at the Fed. There is no reflation, and we are entering a critical phase. Take a look below at the price ratio of the iShares Barclays TIPS Bond Fund ETF (NYSEARCA:TIP) relative to the Pimco 7-15 Year US Treasury Index ETF (NYSEARCA:TENZ). As a reminder, a rising price ratio means the numerator/TIP is outperforming (up more/down less) the denominator/TENZ.
This is one way of tracking inflation expectations. We are at a point where if support does not hold, it is conceivable that a big drop could occur in risk assets. A re-synch is coming between what stocks think about reflation and what bonds think about deflation. If the above ratio is right, bonds will continue to laugh out loud. Nouveaux Bulls will be crying in the meantime.
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