Fed to the res­cue?

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

Mar­cuard’s Mar­ket up­date by GaveKal Dragonom“

That prayer from a young Saint Au­gus­tine sprung to mind when lis­ten­ing to St. Louis’ Fed pres­i­dent, James Bullard, sug­gest last week that the Fed­eral Re­serve may ex­tend its quan­ti­ta­tive eas­ing beyond the planned end date of Oc­to­ber 29. Bullard thinks the Fed should “in­voke that clause about it be­ing data de­pen­dent” and keep buy­ing $15bn worth of trea­suries and mort­gage bonds, at least un­til the fol­low­ing meet­ing in De­cem­ber. Bullard may not be a vot­ing mem­ber, but his ar­gu­ment is lu­cid and we sus­pect that vot­ing mem­bers are likely to be per­suaded. While it won’t fix ev­ery­thing, such a move by the Fed would have a mea­sur­able im­pact on the presently febrile in­vest­ment land­scape.

So why the de­lay? In­fla­tion ex­pec­ta­tions priced into the bond mar­ket have dropped, sig­nif­i­cantly. And as Bullard puts it “the cen­tral bank has to guard against any ex­pec­ta­tions in the mar­ket that would sug­gest that the cen­tral bank is not go­ing to hit its in­fla­tion tar­get.” This is why in­fla­tion ex­pec­ta­tions have long been one of our top mon­e­tary pol­icy in­di­ca­tors. Almost ev­ery time breakeven in­fla­tion rates have dropped sig­nif­i­cantly, the Fed has re­acted with some sort of dovish ma­neu­ver-ei­ther with more QE, more dovish guid­ance... Bullard sug­gests that this time may be no dif­fer­ent.

If the Fed does pause, the length of the de­lay will de­pend on how real or tem­po­rary the slide in in­fla­tion ex­pec­ta­tions proves to be. If the medium-term out­look for in­fla­tion has soft­ened, then it could take more time, and per­haps more stim­u­lus, to turn the sit­u­a­tion around. In­deed, mar­kets have re­cently pro­vided plenty of in­di­ca­tions that this might be the case. Per­haps, the world is plod­ding to­wards de­fla­tion. But there is also the pos­si­bil­ity that bond mar­ket sig­nals are tem­po­rar­ily dis­torted. For his part, Bullard is stick­ing to his own fore­cast for ris­ing in­fla­tion. With the no­table ex­cep­tion of fall­ing com­mod­ity prices, we too find sev­eral sup­ports for US in­fla­tion go­ing for­ward. So what could be dis­tort­ing bond mar­ket sig­nals to­day? The list is plen­ti­ful: 1. Eu­ro­zone woes - Re­newed trou­ble on the old con­ti­nent is caus­ing a flight to US trea­suries and also rais­ing fears of an eco­nomic knock-on ef­fect that de­rails the US re­cov­ery. Bullard does not yet see such a sit­u­a­tion, but he says there are good rea­sons to adopt a wait-and-see ap­proach be­fore QE3 is closed down. As such, the ques­tion is whether some are right in ar­gu­ing that Europe’s out­look could im­prove by Novem­ber or if the sit­u­a­tion de­te­ri­o­rates. 2. Pimco fears - After the Fed, one of the big­gest bond hold­ers is bond man­ager Pimco, with as­sets un­der man­age­ment ex­ceed­ing a tril­lion dol­lars. The firm may bounce back from the loss of its founder and its bond funds may not see the sort of re­demp­tions be­ing widely touted. But un­til this is clear, this is another rea­son for bond in­vestors to seek safety in US trea­suries, even at prices that might not be jus­ti­fied by their own out­look on US growth. 3. Reg­u­la­tors keep push­ing - On Septem­ber 3, US reg­u­la­tors told banks that by the end of the year, they needed to buy more high qual­ity liq­uid as­sets (HQLAs, which of course in­clude trea­suries). The short­fall is es­ti­mated at about $100bn, which could equate to enough forced pur­chases to dis­tort mar­ket price sig­nals. In ad­di­tion, at the start of this week, global reg­u­la­tors warned non-banks that as of 2Q15, they must take big­ger hair­cuts on pri­vate se­cu­ri­ties posted as col­lat­eral for re­pos-of course this ex­cludes gov­ern­ment bonds, and thus makes them more at­trac­tive. So, we have banks, non-banks, and cen­tral banks all buy­ing gov­ern­ment bonds re­gard­less of the price (even when the Fed stops QE, it is still rein­vest­ing pro­ceeds from its mas­sive book).

The above fac­tors not only dis­tort the Fed’s favourite in­fla­tion ex­pec­ta­tion sig­nals, they also make this a very un­for­tu­nate time for it to be end­ing QE. And this is why a decision to de­lay the end of QE would change the in­vest­ment land­scape. QE will still end, but it will not end at the worst of times.

And it will also re­in­stall mar­ket con­fi­dence that not only is the ta­per­ing of QE data de­pen­dent, but so are rate hikes. Of course, the Fed has been say­ing this for a while.

But after Yellen mis­tak­enly told re­porters ear­lier in the year that rate hikes might come “around six months” after the end of QE, she has been look­ing for ev­ery op­por­tu­nity to stress that the pol­icy tra­jec­tory does in­deed de­pend on the data. Bullard is sug­gest­ing that the slide in in­fla­tion ex­pec­ta­tions has pro­vided the ideal op­por­tu­nity to make this point force­fully.

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