What Can Break Treasuries

Aug.25.14 | About: iShares 20+ (TLT)

Summary

Investors and traders turned their focus on the Fed yet again, with the media reciting Yellen’s Jackson Hole comments.

What happens in the U.S. may end up being a side show relative to Europe now.

If Draghi initiates QE and inflation expectations rise, then European yields likely rise and that could finally break the Treasury uptrend.

"We are near, very near, to an end to the eurozone crisis... The worst - in the sense of the fear of the eurozone breaking up - is over. But the best isn't there yet." - Francois Hollande

The S&P 500 (NYSEARCA:SPY) rallied as yields nudged higher following the prior week's break in market internals as tensions "eased" in the Ukraine and markets continued to disregard any kind of warning signs that things could get more challenging. Investors and traders turned their focus on the Fed yet again, with the media reciting Yellen's Jackson Hole comments. I suspect the word "slack" is going to be this year's taper in terms of frequency of word use, as the Fed debates when to raise rates with wage reflation still nowhere to be found.

What happens in the U.S. may end up being a side show relative to Europe now. More and more traders and investors are convinced that Quantitative Easing in the Eurozone is inevitable, and that we may see bond buying by the European Central Bank by December. I do not disagree, largely because Germany's economy is now contracting and there is less reason for pushback on large scale monetary action. Inflation expectations have been cratering in Europe, and it remains to be seen if the ECB can indeed reverse that trend.

I have noted before that I find the notion that QE can reverse deflationary pressure curious, given that QE failed to achieve its objectives in Japan and the US. However, if Draghi initiates QE and inflation expectations rise, then European yields likely rise and that could finally break the Treasury uptrend (NYSEARCA:TLT) and high correlation over the last several months between stocks and bonds. This is much needed for alternative strategies like our primary inflation rotation approach. In a world where everything is correlated to the upside, the only way to be uncorrelated is to not participate to the same extent. Every time a central bank has initiated QE, yields rose. If this happens in Europe, it would take US Treasuries down and finally create a marginal rising rate environment so many have been wrong on for so long.

As correlations normalize and the Fed gets out of QE, we fully expect more normalized intermarket relationships to take hold, which from the standpoint of tactical trading across asset classes and sectors is a very positive thing for our strategies. Every day we get closer to that type of environment which can meaningfully alter the signaling power of the inputs that go into our primary risk trigger which causes us to rotate into or out of various investable instruments. I continue to be very excited for that environment to reassert itself as it did in 2012 which was a particularly strong year for our ATAC approach.

The coming week will be another one filled with travel for me. For those in Kansas City, I encourage you to sign up to my CFA presentation on predicting stock market volatility and corrections by registering here. From the standpoint of asset class choice and sector movement, small-caps may begin to stage a period of near-term outperformance, and energy (from a beta rotation standpoint) could finally begin to strengthen after meaningful weakness.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.