Before even taking one step further, please be aware that this discussion is being written prior to the outcome of the Greek elections and June FOMC meeting. By the time you read this the commentary to follow may be null and void for all I know. As of the close last week, investors had bid up many an asset price supposedly based on the anticipation of global central bankers being ready to “act” if the outcome of the Greek election were to precipitate financial market distress. As you know, last Friday was triple witching expiration. And Reuters just had to release a story 30 minutes (of market time) prior to options expiration about the possibility of a potential and very near term global central banker monetary policy response. They could not have waited 31 minutes until after the market close could they? Of course it was maximum impact on cratering put prices set to expire in 30 minutes of “market time”. I’m sure it was just one big coincidence. Exactly the kind of coincidence Greenspan engineered time and again under his own monetary reign of terror, remember?
To the point, I personally believe the Fed will not commit to a formal QE at today’s meeting. Why? We have not yet hit a proper “tipping point”. As you’ll see below, as of the moment, the TIPS breakeven inflation rate is well above what was seen at the initiation of QE2 and Operation Twist. Although I have not taken the chart back, this number was near 0.3% in early 2009 when QE1 was being formulated. Key point being, the TIPS breakeven inflation rate is higher today than at any time in the current cycle when the Fed has initiated yet another dose of monetary action. It’s simply not time yet as per the message of the market itself for the Fed to act. The current TIPS breakeven inflation rate number stands at 2.11%. The prior two monetary events were initiated at 1.49% and 1.71% respectively. Of course what we are seeing is “higher highs” in implied inflation rates with each successive iteration of policy easing. From a chartist perspective, it suggests that at some point the implied inflation rate will “breakout” to the upside, but we’re not there yet. This is a discussion theme for another day.
In recent and collective commentary, the Fed has been pretty darn clear on the specific conditions for further policy acceleration. Meaningful slowing in the economy is one condition. Yes, we’ve seen slowing, but current LEIs do not look like 2010 and 2011 periods where monetary action was initiated. Heightened labor market softness is another. And what you see below is heightened labor market softness? Not yet.
Finally, accelerating deflationary risks are the final box to be checked by the Fed for a monetary policy response. The TIPS chart above already showed us that accelerating deflationary tendencies are not really present, especially relative to recent historical perspective. It’s clear in the TIPS chart that post the initiation of each round of additional monetary stimulus, the implied inflation rate shot skyward 75 to 100 basis points. If additional monetary stimulus was applied now and the pattern of a rising implied inflation rate seen in this cycle was repeated, the implied inflation rate would head to a new high for the current cycle. And that would go unnoticed by market participants? I think not. Is this why Bernanke has all of a sudden started talking about the potential downside “costs” of additional policy measures? I believe he is exactly referring to market determined implied inflation rates.
Personally, I expect the Fed to jawbone, as has been the exact case YTD. Let’s face it, when it comes to the reality of impact, just how will additional Fed stimulus/balance sheet expansion right now change the fundamental dynamics of Europe? It won’t. Can the Fed really do anything to meaningfully offset or blunt the fiscal cliff issue firmly in the decision making hands of the politicians? Nope. Lastly, relative to election impact, time is the enemy right now. Politicians dreaming of additional QE for supposed voter support do not want a financial market peaking “too soon” prior to November. Although I will not dredge up the chart again, each iteration of QE/stimulus has witnessed a diminished positive directional market impact in terms of time (number of months of market rally). As a tangential comment, the recent Spanish bailout news had a positive financial market impact that was down to being measured in hours. My own guess is that action in late July or August would be much closer to the political mark.
Again, I’m guessing, but the next iteration of Fed sponsored QE will be an asset purchase/balance sheet expansion program. The structure of the current Fed balance sheet does not allow for more twist of any meaningful amount. Additionally, the number needs to be relatively big, especially in light of the European debacle and clear slowing in emerging economies that were absent in prior QE adventures.
I’ll leave you with one final thought. Although I’ll skip an exhaustive quantitative thesis and proof, the price of gold historically has been positively correlated with the TIPS implied inflation rate. In fact, in the current cycle as the TIPS implied inflation rate has fallen meaningfully in 2010 and 2011, gold has rallied clearly in anticipation of a monetary response and resumption of higher implied inflation to come. During the current, albeit modest, decline in the implied inflation rate, gold has not rallied as it did in the prior two years. Is gold also telling us “not yet” for another round of QE? It sure appears as such, at least for now.
Again, my apologies as I know that by the time you see this, market reaction to the Greek elections and the Fed’s meeting commentary will have most likely played out. Worst case, I hope the “road markers” I’ve discussed will serve as helpful guideposts to the actual initiation of the next QE as we move through the summer. What that means for the markets themselves will be another question all together, given the near constant anticipation of such throughout the current year so far. Although this is a very generic comment, my gut is telling me that with each additional stimulus announcement, regardless of geographic central bank, we’re coming ever closer to a potential sell the news event.
