Fed to the rescue?

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.