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It appears that the Fed is nearing the point of starting to taper its massive asset purchasing program. The program succeeded in pushing interest rates to all-time lows as the Fed became the largest single purchaser of Treasury bonds and mortgage backed securities over the years since the financial crisis.

During this time, much of the private and institutional money flows that would normally go into bonds were diverted into stocks as the bond yields were forced to unattractively low levels, and the majority of bond issuance was gobbled up by the Fed.

Historically, the vast majority of bond buyers are investors--not traders. Generally, investors buy bonds with the intent of having a stable place to park their capital while collecting the coupon yield, which gives them a steady return.

As the Fed tapers and a greater portion of bond issuances are available to normal investors, interest rates will likely rise. In fact, we are already seeing this in the wake of the minutes of the last Fed meeting that hint at tapering starting soon.

^AXTEN Chart

^AXTEN data by YCharts

Given that the primary reason for buying bonds is the coupon yield combined with a safe place to park capital, it would stand to reason that investors who plan to hold bonds to maturity would be more attracted to them when there is a higher yield.

The Potential Flaw In The Standard "Great Rotation" Theory:

There has been a lot of speculation in regards to a "great rotation" from bonds to stocks because bond yields and bond prices move inversely to each other. The theory is that as bond yields rise and bond prices move down, bond holders will dump their bonds and buy stocks.

The problem as I see it with this theory, is that stocks have been pushed up to all-time high levels over the last few years largely in reaction to the Fed sucking up the lion's share of bonds and keeping rates unattractively low.

Now stocks are not looking very cheap and if you get rising bond yields a significant number of investors that have ridden the stock rally up are likely to rotate into the soon-to-be higher yielding bonds with the intent of holding them to maturity.

Basically, as the Fed stops pumping $85 billion per month into the bond and MBS markets and yields rise, the markets are likely to normalize, which will see regular bond buyers come back into the bond market attracted by more normal yield returns. Meanwhile, the massive money flows that have been forced into stocks as a result of a restricted bond market will taper off, capping the recent parabolic rise in stocks.

It is likely in my view, that the taper of Fed asset buying could create a relative lack of demand in stocks as opposed to the standard "great rotation" theory. This is because higher-yielding bonds will look attractive to investors facing a climate where stocks are relatively expensive, considering overall economic health and upcoming demographic challenges of about 10,000 baby boomers retiring per day. Slow growth is a best-case scenario given the demographic, fiscal and economic challenges on the horizon. This does not create an environment for the continued long-term rise of the equity markets.

Conclusion

Watch for a top in U.S. stock markets around the time that the Fed taper begins, as explained in the scenario above. Look for a potential near-term pop in interest rates up to levels where bond investors start to fill the demand gap left by a tapering Fed. I expect a significant stock market decline to accompany an interest rate rise, as equities have reached a state of euphoria buying over the last few months.

Shorting U.S. stock indexes, as well as shorting bonds in the near-term, could be a profitable trade. However, my expectation is that the stock index shorts could run significantly longer than the bond shorts but bond shorts will likely be profitable before the stock shorts.

ETFs that can be used to trade bonds include: (TLT), (TBT).

ETFs that can be used to trade the U.S. equity indexes include (SPY), (SDS), (DIA), (QQQ).


Disclosure: I am long TBT, Short SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: Nothing in this article is to be taken as professional financial advice, nor is it a solicitation to buy or sell any type of securities. All financial decisions are your own, seek professional advice before taking action.

Source: The 'Great Rotation' May Be Very Different Than Many Think