Why Fed Wants A Correction

Includes: EEM, SPY, TENZ, XRT
by: Michael A. Gayed, CFA

"The three pillars of learning; seeing much, suffering much, and studying much." - Isaac D'Israeli

The S&P 500 (NYSEARCA:SPY) yet again behaved in a volatile way last week as "risk-off" dynamics continue. US equities had their worst month in more than a year as economic data continues to soften. The "rising rate environment" crowd continues to be surprised by how Treasuries (NYSEARCA:TENZ) are acting, especially in light of credit spreads widening and the deflation pulse that began beating quickly post weak payroll report. Pending home sales missed by a wide margin, durable goods disappointed, and the upward trajectory of home prices softened. All of this suggests very simply that the economy may not be able to handle higher rates, which explains the sharp drop in yields our ATAC models used for managing our mutual fund and separate accounts were about to take advantage of.

Indeed the media continues to focus on the "emerging market crisis" when in reality it is a US reflation crisis to be most concerned about. Retailers (NYSEARCA:XRT) in January were down more than emerging markets (NYSEARCA:EEM), completely surprising money that believed the "wealth effect" would benefit consumers. Amazon, for the first time in a long time, cratered on its earnings announcement. The consumer story is under attack with housing potentially weakening again, which in turn makes the demand pull reflation case highly suspect. In addition, inflation data in Europe continues to worsen as Draghi's "whatever it takes" line wears off.

Yet, despite this, the Fed decided to taper again. We suspect that the central bank wants out of Quantitative Easing given the growing realization that it simply has failed to force reflation into the system, and instead has increased risk to financial markets. The Fed likely wants a correction here for two reasons. The first would be to allow some froth to come out of risk assets, particularly high yielding credit which is showing very low spreads relative to inflation expectations. The second is to allow the marketplace to replace their bond buying. The Fed still wants low rates, but wants them without as much intervention on their end. The best way for this to happen would be through a risk-off period whereby money flees risk assets to push Treasury yields lower at the same time the Fed is stepping away.

If this is the correction, then markets likely have much further to fall, and what would solidify that is another weak payroll report. The Great Convergence between US stocks and inflation expectations appears to be underway. Initially it seemed that inflation expectations would rise, but as emerging markets faltered, it may end up being the other way around. Complacency still remains extremely high, put/call ratios still show relatively little fear, and everyone continues to believe 2013 is the right playbook despite its outlier behavior. If the deflation pulse does not soon reverse, a sobering moment may come sooner than most think. How it ends is anyone's guess, but I suspect that it will be emerging markets that lead the way out of a corrective environment.

US Treasuries surprised everyone in January, and there will come a time when emerging markets do the same when relative momentum definitively reverses. For us, the dream setup is simple: benefit from risk-off dynamics in long duration Treasuries, then position into emerging market stocks on the inevitable turn higher. Both are highly bombed out trades, and have significant potential to perform strongly to resync relationships relative to last year's intermarket movement. While this may be a time to refresh the fear with Treasuries getting a bid, this at the same time may be the purge that refreshes for emerging markets.

Markets are re-learning cause and effect. We never forgot it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have 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.

About this article:

Problem with this article? Please tell us. Disagree with this article? .