Wednesday, February 20, 2013
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.