The hidden reason why the Fed will taper: Pro
If you think the Federal Reserve is happy with the recent rise in rates, then you're wrong. The Fed has to be quite uncomfortable with the velocity of this recent move, which has seen the 10-year yield climb up from 1.6 percent to 2.9 percent in just 3½ months. Meanwhile, one of the biggest misperceptions in the market today is that equities have properly digested this massive move.
So how does the Fed allow the market to acclimate to the rate rise, and keep the 10 year-yield suppressed specifically under 3 percent, even as the marginal efficacy of quantitative easing is being questioned? Simple: They minimally reduce (a.k.a. "taper") QE in September, to the tune of $10 billion to $15 billion.
(Read more: The 3 reasons everyone is dead wrong about bonds)
Why will that work?
Well, the Fed has certainly softened the landing strip dramatically this year, as the S&P 500 is still up over 15 percent despite the recent decline. The Fed can easily afford to let equities retrace 6 to 8 percent. And tapering will show the market that there could be some risk in equities, which will send people running for safety, and thus put a bid back in to the Treasury market. This will keep the 10-year yield closer to 2.5 percent than 3 percent.
(Read more: For bond investors, it feels a lot like 1994)
Keeping yields below 3 percent is absolutely crucial for the Fed. After all, it doesn't just have Wall Street to worry about — a massive increase in borrowing costs affects businesses everywhere, as well as the government.
Treasurys are indeed oversold, but the correlation trade—stocks and Treasurys falling together—will persist until a real equity correction is revealed (or recognized). Still, the recent emerging markets selloff has left us poised to buy Treasurys, as safe havens will soon be sought after yet again.