Correction or Pause? Here’s The Indicator to Watch.

The Dollar Index and Treasuries both rallied for the first time this week on Wednesday, but the main catalyst wasn’t the better economic data (although that obviously helped).  Instead, the reports in the Washington Post and Huffington Post that Larry Summers appears to be the favorite to become the next Fed chairman weighed on Treasuries.

It was widely assumed, up until a few weeks ago, that Bernanke would be replaced by Fed Vice-Chairman Janet Yellen, who is considered an “ultra-dove” and would err on the side of being “more dovish” whether tapering was occurring or not.  Basically, she’s viewed as an extension of Bernanke.  Summers, if he gets the job, is relatively unknown with regard to his views on monetary policy—and it’s almost a certainty that he wouldn’t be as dovish as Yellen.  So, Summers becoming the favorite to replace Bernanke is, in a way, a bit of a “hawkish” event compared to current expectations. This was the real catalyst behind the Treasury sell-off and the dollar rally yesterday.

Treasuries sold off hard yesterday, as the 30-year note fell 0.65% thanks to the Summers articles and the better than expected economic data.  Rising yields remain the most fundamentally sound trend in the market today. The economy is rebounding; the Fed is turning “less dovish” both in practice and, it appears, in personnel (if Summers is nominated, which is a big “if”); and the job market is improving.  On the charts, it looks as through the 30-year Treasury has failed at the first major resistance, and I think the downtrend in bonds/rally in yields is back on after this three-week-long, counter-trend rally.

Bottom Line

Yesterday was a good reminder that, while the stock market may be comfortable with Fed “tapering” in September, the expected rise in interest rates needs to be “orderly,” otherwise we’ll see a repeat of the turmoil in June.

That said, this market (domestically and internationally) feels a bit “tired” and, like most things that are tired, the market is probably overreacting a bit to the uptick in yields yesterday and this morning.  But, the key will be the emerging markets.  If PCY and EMB start declining sharply again, that’s a sign this could be another bout of money flows out of emerging market like we saw in June, and that would be a negative for equities.

But, yesterday was another reminder that, while the market will continue to adjust to the idea of higher yields, the way to play that is to get exposure to higher yields (they are the constant here, not the market rallying).  So, I’d continue to look to do that methodically via ETF’s like TBF, TBT, SJB and allocations out of “bond proxy” sectors like utilities, REITs and telecom, and towards financials and more cyclical stocks.