Wednesday, February 20, 2013

Fee Fi Fo FOMC.

Fee Fi Fo FOMC. Do the Fed Smell the Blood of Inflation?

First we must share a video produced by one of our readers under the name "Becky Quick". We have seen the Hitler rant in the "Downfall" film used many times but think this one of the ECRI facing up to their recession call is by far the best. Thank you Becky.



And once you have wiped the tears from your eyes let's move on.

Last week we mentioned that we were mulling over whether, after seeing our expected correction period in equities do little more than flatline, it's time to get back aboard the bus. Having waited dutifully for any holiday inspired dip to occur (not) or for someone in the political sphere to break ranks and go "Tourettes" on us screaming all sorts of financial profanities, we have been somewhat impressed by the the way the thin red line of Global Unity has held together. Granted, such unity resulted in probably the most custard cream of G20 statements, with sweet blandness swamping any hint of savoury nuance that the market could digest as new nourishment, but it's done its job. Well done everyone.

This leaves us wondering if this bout of STFU policy will persist long enough to allow the next run up it risk assets and currencies. But as was pointed out to us by a reader, currencies are no longer Risk On Risk Off (RORO) but rather split into Too Weak And Too Strong ( T.. ahhm never mind).

So how quiet is it likely to remain? This week sees a slew of US data, but TMM are going to use the Fed minutes, rather than the data as their pivot point. For much as we saw Dr. Aghi's ECB statement disappoint a market skewed towards valedictory expectation and much as we saw Carney's first words disappoint a market expecting him to slash rates further and confine GBP to the toilet (GBP, we hasten to add, is flushing itself down the toilet without any help from Carney), we also think there is a dramatic skew in expectation towards the Fed minutes. While the consensus view may be something along the lines of, "Head's down, no nonsense mindless QE boogie, bang your head on a wall" (prizes for the song ref there) TMM thinks that it may actually be the most interesting batch of minutes released in a while.

Recently, statements from the Fed (indeed from almost all major central banks) have started to suggest that they CB's have changed their reaction functions, placing larger weight on employment and lower weight on short term inflation. This is desirable, so the wisdom goes, because G7 economies are all dealing with liquidity traps. As a result, whilst long term inflation expectations remain anchored, the Fed can continue to conduct QE in order to help growth without losing any inflation fighting credibility. So far so good.

Note, however, that 'anchored' is VERY loosely defined. Is there a range for long term inflation expectations that is acceptable? If so, is that range itself a function of where the unemployment rate is as the FED have often hinted? Or a function of the length of a special someone's beard?

However we may get a clue tomorrow and we think it may be triggered by what has been happening to long term inflation expectations as proxied by 10 year inflation break evens, which are now at their highest level on a sustained basis in almost 2 years. The last time this occurred, both subsequent FOMC statements (dates marked by the vertical white lines on the far left of the chart) included references to them.





In the March 15th, 2011 statement, the FOMC added:
"The recent increases in the prices of energy and other commodities are currently putting upward pressure on inflation. The Committee expects these effects to be transitory, but it will pay close attention to the evolution of inflation and inflation expectations."

Now, to be clear, TMM does NOT expect a change in the size of the Fed's QE program resulting from this. But the simple introduction of inflation expectation risks to FOMC minutes, after a multi year absence, could have quite asymmetric effects on asset prices. This, of course, is because almost everyone expects the Fed to be on hold for the foreseeable future. As a result, the mere whiff of inflation concerns has the risk of changing market perceptions for the evolution of QE, and by extension, risk/reward for risk assets.

Of course, the FOMC is well aware of these issues, which means that any mention of inflation risks is likely to be tempered. But, as TMM has learned after many painful lessons, markets have a tendency to be reflexive and given that so far this issue does not seem to have received much attention in the finance community, TMM is wary.

Lastly, TMM is cognizant of the possibility that the minutes may suggest that the FOMC core may take the opposite view and discount the rise in inflation expectations altogether. If so, TMM would take that as further confirmation of the shift in the Fed's reaction function and will seek to add pro-risk assets as the medics take to the battlefield to apply ursine euthanasia.

26 comments:

Anonymous said...

Alberto y Lost Trios Paranoias, brilliant!
Cheers
DD, not having as much fun in Feb as they've had in Jan unfortunately.

Anonymous said...

C Says'
Still looking for my way in on the otherside of course. For "reflexive" I see it that the issue is rally extension x leverage x shock surprise. I'd be interested to know what had happened to leverage in what are some extended trends in equity and FX (inseperable).The low volatility I am sure will have been a decent marker for leverage to be out in full force again.Really we just need a catalyst be that the Fed statement,or somethingelse.
RSA are the posterchild for this market.Offering huge yield spread bid up well past the very stagnant price range it has had for ages until we finally have a trending stock at a price "reflexive" to an unthinkable event of divi chop! Double digit smash.Really all we need is an event that is rather more than stock specific and we will have a similar market responsecourtesy of leverage.

Polemic said...

Well done DD.. didn t think there would be many who remember them

C.. if we are solely hoping for an unknown then we are afraid we are in hope land rather than any other land. And as we have said before, we feel eqs can go up with levearge right to the point kirsty alsop switches pumping houses to pumping stocks on tv.

Anonymous said...

C,

besides what is going on in div stocks there were some comments from Einhorn during an interview a couple of weeks ago. It seems a little like everyone is back in 2007 mode. Leverage as leverage can. Unfortunately you see where it was hiding only after the fact, on its way stampeding out.

Eddie

Anonymous said...

Leverage at this stage looks more like 2004 than 2007 to me.
DD

Anonymous said...

c says'
show me

Anonymous said...

C Says'
That came out rather more abruptly than intended. Yet I would like to see the data,because everything I know about behaviour links low volatility (expected low risk) to higher usage of leverage.

Pol,
I'm not in "hopeland". At this juncture it simply becomes do I want to chase extended trends that don't have much to do with fundamental improvements in economic data. When I look at where the mom is in FX and the economic data associated with it I just think 'come to daddy'.I don't think I will have that long to wait for a route in.

Anonymous said...

C Says'
As an aside waiting is so much more interesting these days.Technology,thank you google,opens up new horizons. For example, I ran 13kms around Copenhagen yesterday morning and another 10kms along Cocoa beach this AM.Indeed I've run 100kms in the last week on 4 different continents without leaving my gym/office.It makes 'doing nothing' which is hard work so much easier to do as long as you don't have to answer to some idiot who confuses activity with meaningful results.

Leftback said...

Correct, TMM. Markets yawning at the data, in ZIRP World it is indeed all about liquidity expectations, and so only the FOMC has the potential to move markets.

Anonymous said...

This one has yet to be topped:
http://www.youtube.com/watch?v=6YkzBSjD_ig

Anonymous said...

C, my 2004 was a bit of an exaggeration but in my little corner of the world even though LBOs are back, the purchasers of the debt are nowhere as structurally levered (40x levered, monoline businesses, CP-funded vehicles have been replaced by good old pension money, not that they cannot be wrong either, obviously) as they used to be in 2007.

I am just remembering having learned the hard way during 05-06 that once it gets going the leverage chase can sometimes go much further than you would think imaginable (even if in the end as Mr Rosie would say, it doesnt correct by going sideways).

DD

Leftback said...

Ask and ye shall receive:

Heads Down No Nonsense

Although the inspiration for this parody is almost a perfect self-parody of the genre. Here they are, the late, great Status Quo:

Down Down

abee crombie said...

leverage and securitization is back, but really it is the underwriting standards that are the harbinger of troubles. The leverage amount is a reflexive process and I too think it is more like 2004 vs 2007 but that doesnt mean much.

TMMs post is interesting. At some point in the near future (one would hope) we will witness the Fed step away from QE buying. That should be a nice test for equities. Yes the Fed will be on hold until the dollar collapses or inflation is adjusted away but like TMM said, once the market starts thinking of a possible end to QE buying it will be interesting.

Nice trend down in bonds but nothing crazy

Leftback said...

and there it is folks, the T word:

"A number of participants stated that an ongoing evaluation of the efficacy, costs, and risks of asset purchases might well lead the Committee to taper or end its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred."

Mr Market isn't delighted with the T word, and the DX hits its first target level of 81. Mr Bond seems to be reacting to the news with equanimity, whereas Goldfinger is... wait a minute, where is Goldfinger?

Gold Plummets

Anonymous said...

Don't worry, gold longs. It's contained....

Leftback said...

Not sure what you think TMM, but it looks very much like two markets over here this arvo. Stodgy divis like VZ and MRK are up, while all kinds of beta is having a rough go of it today. Growth to value rotation by long only funds, obviously this is usually a bearish development.

Polemic said...

To be honest LB missed most of it, been out on a bicycle in a freezing wind better get on and read it all....

amplitudeinthehouse said...

That's timing if I've ever seen it , Pol...

Yeah,yeah..I'll keep my head firmly in the research blogs...

oh...look at that!.... induction..I'm learning correlation doesn't mean causation...

Anonymous said...

C Says'
Good call on the Fed.

Anonymous said...

C Says'
The £ will now start handing out some real pain.Levels look right for the reversal.What has gone before was basically b..shit,but who would deny the market it's right to have it's helping of that.

Anonymous said...

C says
onlt 2 not in the red on the ftse and of them 1 dropped double sigit yesterday and the other stuffed revenue ,but promised a buyback.
Shep the sheepdog is earning his money rounding up the sheep today.What I meant to say is the fortitude of these ironclad buy and hold investors is a credit to our species.

Anonymous said...

C Says'
We have about 2 years worth of sideways action on the AUD$/US$.Good moves eventually come from ranges that have soaked up a lot of action. Coin flip stuff,but given the context elsewhere it appears worth it to me to have the AUD$ on a sell now for a trending move.Economically they still have a very overpriced property market,and now lagging comms are getting roasted.One would expect some marking in for further rate cuts.Anyway,I talked myself into it ;)

Anonymous said...

Why oh why is AUD so sticky?
So damn frustrating
DD

Anonymous said...

Fun post timing, C
I have that one on (and some AGB duration on top), and although it hasnt been too costly so far, the wait is very painful
DD

Peter. O said...

Excellent video indeed

Stephan White said...

leverage and securitization is back, but really it is the underwriting standards that are the harbinger of troubles. The leverage amount is a reflexive process and I too think it is more like 2004 vs 2007 but that doesnt mean much.

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