Draghi Saves Alternatives

“If saving money is wrong, I don't want to be right!” - William Shatner

In a world where bonds and stocks have correlated in an unusually high way, any kind of risk trigger has been vulnerable to whipsaws. Why? Because a risk trigger in an active, alternative strategy assumes to some extent that uncorrelated opportunities exist, and that in turn results in risk mitigation during conditions that historically favor heightened market volatility. The Federal Reserve’s winding down of Quantitative Easing has increased the correlation of Treasuries to stocks. Now, with the European Central Bank surprising markets with not just further aggressive rate cuts, but also an asset backed securities and covered bond buying program, the stage is set for a Quantitative Easing-style juncture in the Eurozone.

A couple of weeks ago, I mentioned the idea that any kind of Quantitative Easing in Europe may end up breaking Treasuries. Every single round of QE has only resulted in yields rising as central banks buy bonds, crowding money out into stocks and risk assets regardless of whether that actually benefits the economy. If the market begins to treat Draghi’s monetary policy moves as QE-like, then it stands to reason that European bond yields begin to rise, in turn sending Treasuries lower in price with them.

I didn’t think two weeks after bringing up that possibility that we would soon see such a move, but it does appear that Draghi is intent on flexing some monetary muscle to counter deflation in Europe. So far, the ECB’s measures are working to break down the euro, which can certainly be inflationary. However, the ramifications of a weaker wuro on all other countries is going to be important to watch. If the euro were to make a move towards parity against the US dollar, with poor payroll data and still no reflation in sight, it will keep the Fed on hold for longer than market participants thinks. It also would be a net negative for the economy is Draghi’s stimulus does not stimulate growth.

Since May 2013, risk triggers have not worked despite historical relationships tested across multiple cycles and decades, largely because of correlations that got very out of sync with underlying reality. If Draghi broke Treasuries, that can be very good for any alternative strategy that relies on correlations to hold for active and tactical risk management. If Draghi did NOT break Treasuries, and stocks begin to sell off, this too would be beneficial as it would still resolve the Treasury/stock correlation in 2014. Regardless, for our alternative strategy, that is what we need to see happen. For our equity sector beta rotation strategy, that should cause sector differentiation to become heightened and allow for alpha generation.

The fundamental problem all along has been simple: bonds and stocks have vastly disagreed on growth and inflation expectations. One by definition must be wrong. Historically, bonds tend to be more right than wrong than stocks about the future, because bond investors focus first and foremost on return of capital rather than return on capital. Our underlying core thesis all along has been that Treasuries are right, and inflation data does confirm this notion. However, for a moment in time, Draghi may make Treasuries wrong about the future. If he doesn’t and bonds do not budge, then a severe breakdown in faith in central banks to force reflation will likely come sooner than anyone is prepared in their portfolios to hedge against.