Thursday November 5, 2009 - 15:29:32 GMT
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Fed Set Self Up for Expectations War with Marketc
Fed Set Self Up for Expectations War with Market
Now that we have the Fedâ€™s three conditions for low rates from the statement to mull over â€“ excess resource slack, subdued inflation expectations and low inflation, one does not need much of an imagination in world populated with bipolar risk takers to project in the very near-term an expectations management problem for the Fed.
Inflation expectations (market expectations) are about as stable as a bottle of nitroglycerin. Headline inflation should soon take off as year-over-year comparisons see effects from a drop in record oil prices in 2008 disappear. Weak USD concerns and a need for reserve diversification are powering commodity prices higher, namely gold (for many an inflation expectations barometer). And positive growth is for many rate traders itchy for a big move to put aside high unemployment and slack resource worries in no time.
The problem for the Fed is that by unleashing markets to ponder future inflation as arguably happened in Wednesdayâ€™s statement has set up at the very least a new short-term tradeâ€¦curve steepeners, rally in TIPS and ever higher carry trades (thanks to Roubini this now is euphemism for short dollars, long gold, long high yieldâ€¦a new catchall).
However, the Fed Board and Bill Dudley still worry that the main risk to future price stability and full employment from a policy standpoint comes from removing stimulus too early. Unless the Fed doves are confident the Obama admin and Congress will more than make up for headwinds from higher market rates ahead (in face of rising inflation expectations and when Fed is wedded to low rates for at least 6 more months), it is difficult to see how the Fed can avoid a major confrontation with the bond market over inflation expectations. If the curve steepens too much too fast it could derail any hopes of a recovery in the private sector, where the odds are already stacked against it in light of household balance sheet adjustments (high savings), limited business investment (record excess capacity) and tight credit conditions. A steeper curve may help banks get back on their feet sooner (wealth transfer from gvt), but if they do not lend to private agents, it wonâ€™t do much for GDP and employment ahead.
Okay I may be overstating the significance of Fed word choice in a statement and this inflation expectation war would have happened if the language was not added to Wednesdayâ€™s statement. However, the Fed is responsible for language parsing game and there are huge stakes for risk takers in betting on this parsing. With the inflation expectation barn doors open (sanctioned), I think prematurely, the Fed will face a heck of a time managing market rates aheadâ€¦and in an environment of huge bond issuance (luckily Asia still manages FX regimes and banks are stockpiling US gvt debt to ride spread income).
Press the inflation bet for the next quarter (markets are notoriously prone to irrational overreaction at inflexion points) and then get ready for the next deflation expectations trade when the private sector is a no show in 2010.
If I had to guess, the insertion of the conditions for low rates was added to the statement to placate the hawks on the FOMC and maintain appearances of a consensus. This suggests some interesting minutes in a few weeks time assuming the Fed is comfortable revealing member differences (transparency outweighs potential for damage to asset prices by revelation).
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