Via Guy Haselmann of Scotiabank,
‘Taper-talk’ in May sent US 10yr rates higher by over 100 bps off their lows. Since Bond prices are essentially capped at par, the distribution curve for bonds became skewed to the downside as they neared the zero-bound – a significant a-symmetric risk reward. The proceeds moved into equities which has no upside limitations. Portfolio manager even moved into dividend paying stocks as a substitute for Fixed Income exposure. This flow over the last few months now seems to be shifting in the other direction.
Furthermore, the FOMC may be drifting toward having to taper, NOT because it will achieve economic targets, but rather because the risks to financial instability are becoming too great. At the end of the day, equity prices have to be justified by their earnings and prospective earnings. It is hard to see where earnings and revenue growth will come from in a slow growing economy. Monetary policy seems to have done all it can with its limited tools to help economic growth. Therefore, the risk reward profile for equities - exacerbated by over-exposed asset managers - may trigger asset allocation re-adjustments.
In addition, markets, risk assets in particular, do not like political dis-unity. The FOMC seem dis-unified; delivery differing messages. Comments by Dudley and Fisher were not just marginally different, but rather stark contrasts. Trust in the Fed and in its’ communication strategy have been tarnished. Markets are now confused as to when, why, and how the Fed will be able to change course.
Moreover, the Tea Party wing seems to have hijacked the Republican Party into threatening a Government shutdown and possibly even a default. Sequestration seems alive and well and the economy may be on the verge of a slowdown, rather than acceleration. Treasuries may need to demand a higher liquidity premium for the moment. I am confident that when the taper is in full-swing that equities and bonds will drift to lower prices. However, the immediate trade may require paring risk, and rebalancing portfolios, i.e. stocks down, bonds drifting higher in price (risk off).