By
The
Inflation Trader
:
On Wednesday, Fox News was showing live video of police in Los
Angeles chasing bank robbers escaping in an SUV. The bank robbers
began to throw cash out the window (
see picture below
), apparently hoping to have the streets behind them blocked by the
scores of people scooping up free money.
(click to enlarge)
It didn't work, and the robbers were apprehended. Of course, it
didn't work - that money isn't worth what it used to be, and anyway
the Federal Reserve today was on schedule to throw a heck of a lot
more money than
that
out the window.
And throw they did - in fact, in recognition of the similarity
between the money-flinging bandits and the Federal Reserve chief, I
move that we retire "Helicopter Ben" as a moniker in favor of
"Mercedes Ben," which anyway has a better ring to it (and a
built-in song). Interestingly, despite all indications - quite
deafening indications to anyone who has listened to Fedspeak for
any length of time - that the Fed was planning another dose of QE,
a surprising number of investors were evidently surprised. There
were no bad bets from the long side today: stocks launched higher
on the news, gaining 1.6% to four-and-a-half-year highs.
The DJ-UBS commodity index rose 0.7% to a one-year high (up 18%
since mid-June). Treasuries gained (although it is hard to fathom
exactly why, since the Fed will be buying mortgages, not
Treasuries), with the 10-year note rallying 4bps to 1.72%; but TIPS
launched higher with 10-year yields falling 13bps (to an all-time
low of -0.76%) and the 5-year TIPS dropping 16.5bps to -1.62%. This
sent breakevens sharply wider, with 10-year breakevens up 9bps on
the day to 2.48%, the highest since last May. The all-time high for
10-year breakevens is around 2.78%, which is still a fair bit away;
but, by the same token, 10-year breakevens touched 0% in late 2008,
had lows of 1.52% in 2010 and 1.71% in 2011, and are up 41bps since
July 26 (
see Chart, source Bloomberg
).
(click to enlarge)
Meanwhile, 5y inflation, 5 years forward, extracted from
inflation swaps quotes (which is the proper way to do it, rather
than looking at a pair of idiosyncratic bond breakevens), is at
2.98%, threatening to break the 3% level for the first time (other
than during a quick spike in March) since last year. And that's as
the Fed
starts
QE3.
One thing is sure, and that's that at least one investor out
there is very, very unhappy today. That's because over the last few
days, someone bought at least $2 billion in 0% zero coupon
inflation floors, in 5-year and 10-year tenors, in the interbank
market over the last few days (and who knows if more traded
directly on a dealer-to-dealer basis). A 5-year 0% zero coupon
inflation floor will pay off only if there is net deflation over
the next 5 years; for the 10-year 0% floor, the deflation will have
to persist for a full decade.
These floors are analogous to what is found in TIPS themselves,
so there is a chance that the dealer buying these floors is
preparing a TIPS-like inflation-linked bond issuance buying them on
behalf of a punter (these days, since banks can't engage in
proprietary trading, it is very unlikely this is a bank bet). The
interbank market is anonymous except to the actual counterparties
who consummate a trade (and regulators, of course), so we are left
to wonder whether there is some plan here or whether some investor
just made a very big bet at exactly the wrong time.
So what was so surprising about the Fed throwing money out the
window? The FOMC statement said, in relevant part:
The Committee is concerned that, without further policy
accommodation, economic growth might not be strong enough to
generate sustained improvement in labor market conditions.
Furthermore, strains in global financial markets continue to
pose significant downside risks to the economic outlook. The
Committee also anticipates that inflation over the medium term
likely would run at or below its 2 percent objective.
To support a stronger economic recovery and to help ensure
that inflation, over time, is at the rate most consistent with
its dual mandate, the Committee agreed today to increase policy
accommodation by purchasing additional agency mortgage-backed
securities at a pace of $40 billion per month. The Committee
also will continue through the end of the year its program to
extend the average maturity of its holdings of securities as
announced in June, and it is maintaining its existing policy of
reinvesting principal payments from its holdings of agency debt
and agency mortgage-backed securities in agency mortgage-backed
securities. These actions, which together will increase the
Committee's holdings of longer-term securities by about $85
billion each month through the end of the year, should put
downward pressure on longer-term interest rates, support
mortgage markets, and help to make broader financial conditions
more accommodative.
The Committee will closely monitor incoming information on
economic and financial developments in coming months. If the
outlook for the labor market does not improve substantially,
the Committee will continue its purchases of agency
mortgage-backed securities, undertake additional asset
purchases, and employ its other policy tools as appropriate
until such improvement is achieved in a context of price
stability.
The
Evans Rule is no longer soft
, as it has been since June. It is still non-parametric, but it is
explicit. The Fed will keep easing (in MBS, "additional asset
purchases," and using "other policy tools") until "the outlook for
the labor market" improves "in a context of price stability."
Bernanke said in his post-meeting presser that the Fed will be
following a "qualitative" approach to easing, and said that if the
economy becomes weaker, "we'll provide more support." More support?
More
support? They're going to run out of things to buy. He said the Fed
won't be "premature" in removing accommodation (translation:
they'll keep programs in place too long, rather than risk being too
brief), a determination echoed elsewhere in the statement:
To support continued progress toward maximum employment and
price stability, the Committee expects that a highly
accommodative stance of monetary policy will remain appropriate
for a considerable time after the economic recovery
strengthens.
Have no fear, however: Mercedes Ben said comfortingly that the
Fed has the "tools and the willpower" to keep inflation low.
Because, you know, if you just have enough willpower everything
will work out just fine.
The purchase of mortgages as opposed to Treasuries is most
likely not primarily driven by a desire to lower mortgage rates,
which are already absurdly low anyway. I suspect that, in a rare
moment of thinking ahead, the Fed realized that since there is
already something of a concern about a shortage of Treasury
collateral with which to margin derivatives trades, leading to a
new Wall Street business "
transforming
" collateral, it will be less disruptive on market function to buy
non-Treasury collateral.
I had expected,
as I wrote back at the end of August
, that the Fed would do QE "perhaps in mortgages instead of or in
addition to Treasuries," and might change the formulation of the
'extended low rates' promise (which was extended to 2015, but that
doesn't mean much now) to be a hard formulation of the Evans Rule.
We didn't get the
hard
formulation of the Evans Rule, but as I say, it's explicit.
It appears that we have not yet gotten a cut in the Interest on
Excess Reserves ((IOER)), which would
probably
be the most-potent easing measure. The IOER is technically not
decided by the full Federal Open Market Committee ((FOMC)), but by
the Board of Governors only - that is, excluding the regional
Federal Reserve Presidents. However, politically speaking, if the
BOG were to cut IOER without the tacit agreement of the rest of the
FOMC, it would make the next meeting a mite testy (plus, there is
the risk of running out of alphabet letters).
So, lump the IOER cut into the "other policy tools" bucket.
The positive response in markets to what was a fairly obvious
policy move - although evidently not obvious to all - suggests that
more is ahead. That is less clear with equities, which have to face
considerably headwinds of European volatility yet, but I would
expect breakevens and commodities to continue to do quite well
going forward.
Tomorrow, the CPI will be released. The consensus call is for a
+0.6% rise in headline prices and +0.2% on core inflation. That
will take the year/year change in headline CPI from 1.4% up to
1.7%. Core inflation is expected to fall from 2.1% to 2.0% y/y,
which indicates that Street economists are expecting a "soft" 0.2%
(one that rounds up to that figure) of 0.16% or 0.18%, since
anything higher than that would cause the y/y change to round up to
2.1% and appear unchanged. If we do
not
get the round-down to 2.0%, we probably aren't going to see it for
a while. The next four months that will slide off the year-on-year
comparison for core inflation are all +0.17% or less.
Thus, August is likely to be a local low, although given the big
downside surprise (for quirky reasons) last month, and given that
the median CPI is still at 2.3%, I frankly think there's a good
chance that core inflation y/y stays at 2.1%.
The next year will be very interesting for inflation. Adding QE3
when core inflation is already at 2% is gutsy, or foolhardy
(depending). At some point, surely the water overtops the dam - no
matter how much "willpower" is applied to stop it. It isn't as if
inflation hasn't been rising already.
Also, tomorrow we'll get Retail Sales (Consensus: +0.8%/+0.7%
ex-autos). It seems incongruous to me, given the economic weakness
of late, that economists are looking for a second straight strong
print from core Retail Sales. Also out tomorrow are Industrial
Production/Capacity Utilization and the University of Michigan
Confidence survey, neither of which matter much.
See also
Irrational Exuberance Doesn't Last
on seekingalpha.com