Conclusion: In analyzing the fine print and market reactions to the latest FOMC minutes, we find potential roadblocks to further easing few and far between. On the flip side, we see that the anticipation of QE2 has grown to a level that opens the door for substantial reporting risk to the downside vs. expectations. In addition, we’ve outlined a mini economic calendar of near-term releases that might surprise meaningfully to the upside or downside, given current market sentiment.
This morning, we got the same question from a couple of our more astute subscribers, asking what would reverse the likelihood of QE2, and perhaps more importantly, market expectations of QE2? The caveat being that this latest melt-up has been fueled by speculation ahead of further easing, so what could erode such speculation, even if just on the margin?
Without doing too much research, we know the quick answer is increased inflation, lower unemployment, and accelerating growth. We are on record stating the latter two of the three options are highly unlikely in the short-to-intermediate term based on our intermediate term forecast(s) for below-consensus GDP growth, negative discretionary spending growth, and declining home values.
Turning back to inflation, we see that Bernanke has turned a blind eye to some of the commodity price headlines of the last several days and weeks. Howard Penney, our U.S. Strategist and Managing Director of Restaurants, pointed a few out in this morning’s Early Look:
(1) Gold trading at a record high for the second straight day
(2) Tin trading at a record high
(3) Cotton at a record high
(4) Copper at a 27-month high
(5) Rubber at a 27-month high
(6) Soybean, Corn and Wheat all approaching 2008 record highs
Since we know Bernanke didn’t see inflation back in 2008 when crude oil was ~$150, for the sake of this analysis, we’re going ignore them alongside the Fed. Digging deeper into their statements, we see that core inflation has trended below the Fed’s target (the latest reading came in at +0.95% YoY in August). Moreover, inflation expectations* have trended below the Fed’s targets as well, which is why they are considering raising the target level of inflation.
We use the asterisk on inflation expectations above because we don’t necessarily agree with their assessment. At best, we’re getting mixed signals from the market: gold at record highs signaling the next hyperinflation vs. yield curve compression signaling disinflation. We leave out TIPS here because the Fed has actually been active in this market, which obviously skews the pricing away from a true market gauge.
To the same extent, the Fed’s actions (or expectations of Fed actions) have caused market participants to front run the Fed by loading up on 10-year treasuries. At yesterday’s auction, 10-year Treasuries yielded 2.475 percent – the lowest since the January 8, 2009 auction! The bid/cover ratio declined slightly, however, to 2.99 from 3.21 in the previous auction. Elsewhere in the Treasury market, we see the spread between 30-year and 10-year Treasuries has widened to a record 138bps, a clear sign of investor demand for medium term Treasuries – the part of the yield curve where QE2 is expected to impact most forcefully.
Elsewhere in the minutes from the September 21st FOMC meeting, we see that expectations also play a key role in deciding when and how forceful to implement further QE2. In light of this, we’ve outlined a mini economic calendar of near-term releases that might surprise meaningfully to the upside or downside, given current market sentiment:
- Now through mid-December – 3Q10 corporate earnings season: If JPM’s results were any indication, earnings could continue to disappoint. Monitoring the inflections and deltas within company guidance will be crucial here (as always). Currently, earnings are expected to be reasonably good.
- October 15th – Bernanke Speaks at the Boston Fed Conference on Monetary Policy in a Low Inflation Environment: Market participants are anticipating further hints of QE2. Likely to not disappoint.
- October 15th – September CPI, September Retail Sales: CPI may surprise to the upside, given the recent commodity and energy inflation. Despite this, the Fed will be watching for the Core Inflation reading, as always. Apparently U.S. consumers don’t have to eat or drive to work... Given that these costs are going up, Retail Sales ex Food and Energy could disappoint.
- October 19th – September Housing Starts: Based on Consensus expectations for single-digit housing price declines, any and all housing data could surprise to the downside.
- October 26th – August Case-Shiller Home Price Index: More so than any other on this list, this release will surprise consensus to the downside, similar to the August 24th Existing Home Sales bomb. The August Case-Shiller data represents contracts signed in April, May, and June – an 8.1% decline from July’s representation.
- October 29th – 3Q10 GDP: Similar to the Case-Shiller number, this release could shock consensus as well. We forecast a deceleration to +1.3% vs. consensus expectations of an acceleration to +1.9%. The rate of growth will be crucial here, as +1.6% is the line in the sand (2Q10 print).
- November 1st – October ISM Manufacturing Index: This series has grown increasingly volatile, inflecting twice in the previous four months. Likely to come in in-line with half of investors’ expectations and surprising to the other half.
- November 2nd – Midterm elections: A Republican rout is priced in and that has been bullish, on the margin, for equities. A Democrat surprise may disappoint current sentiment.
- November 2nd-3rd – FOMC Meeting: The world’s eyes will be focused here.
- December 14th – FOMC Meeting: In case they disappointed in November…
At any rate, it’s clear by all indications that QE2 is getting baked into every market (currency, bond, equity, commodity, etc.). As always, you have to be especially diligent in your risk management when consensus is on one side of the trade. As we stated earlier, QE2 is a near certainty, based on the economic outlook. If, however, it comes in much lighter than expected, look out. The reflation we’ve seen globally could unwind in a real hurry.