Feeling QEeeeesy

Last night’s market action should leave us in no doubt. Equities and commodities are caught in a paradox of US Fed front running.

The market rout emanating from the structural debt problems of the EU and US was arrested briefly last night with the release of new Federal Reserve minutes, which showed, unsurprisingly, a willingness amongst some FOMC members to canvass QE3. Here is the money paragraph:

Participants also discussed the medium-term outlook for monetary policy.  Some participants noted that if economic growth remained too slow to make satisfactory progress toward reducing the unemployment rate and if inflation returned to relatively low levels after the effects of recent transitory  shocks dissipated, it would be appropriate to provide additional monetary policy accommodation.  Others, however, saw the recent configuration of slower growth and higher inflation as suggesting that there might be less slack in labor and product markets than had been thought.  Several participants observed that the necessity of reallocating labor across sectors as the recovery proceeds, as well as the loss of skills caused by high levels of long-term unemployment and permanent separations, may have temporarily reduced the economy’s level of potential output.  In that case, the withdrawal of monetary accommodation may need to begin sooner than currently anticipated in financial markets. A few participants expressed uncertainty about the efficacy of monetary policy in current circumstances. Participants also discussed the medium-term outlook for monetary policy.  Some participants noted that if economic growth remained too slow to make satisfactory progress toward reducing the unemployment rate and if inflation returned to relatively low levels after the effects of recent transitory  shocks dissipated, it would be appropriate to provide additional monetary policy accommodation.  Others, however, saw the recent configuration of slower growth and higher inflation as suggesting that there might be less slack in labor and product markets than had been thought.  Several participants observed that the necessity of reallocating labor across sectors as the recovery proceeds, as well as the loss of skills caused by high levels of long-term unemployment and permanent separations, may have temporarily reduced the economy’s level of potential output.  In that case, the withdrawal of monetary accommodation may need to begin sooner than currently anticipated in financial markets.  A few participants expressed uncertainty about the efficacy of monetary policy in current circumstances but disagreed on the implications for future policy.
A few comments. First, how any economist could see tightness in the US labour market right now is beyond belief. Thankfully, much of the remainder of the minutes were dedicated to discussions of input costs other than labour causing the recent spike in US inflation. In particular, commodity prices:

Participants noted several factors that had contributed  to the increase in inflation this year.  The run-up in energy prices, as well as an increase in prices of other  commodities and imported goods, had boosted both headline and core inflation.  At same time, extremely  low motor vehicle inventories resulting from global supply disruptions in the wake of the Japanese earthquake—by contributing to higher motor vehicle prices—had significantly raised inflation, although participants anticipated that these temporary pressures would  lessen as motor vehicle inventories were rebuilt.  Participants also observed that crude oil prices fell over the  intermeeting period and other commodity prices also  moderated, developments that were likely to damp  headline inflation at the consumer level going forward.  However, a number of participants pointed out that the  recent faster pace of price increases was widespread  across many categories of spending and was evident in  inflation measures such as trimmed means or medians, which exclude the most extreme price movements in  each period.

Much more sensible. But also, the heart of the Fed’s and the market’s problem. The entire commodities complex went through the roof last night, even as equities lost their gains and ended in the red. Markets are now so attuned to the risk trade of a weak $US and emerging market inflation emanating from quantitative easing that the slightest hint of Fed dovishness sends the commodities complex nuts. Of course, that boosts US inflation and cancels out the Fed easing.

Either the Fed is going to have to detonate the world with an inflationary blowoff of QE3 or commodities must crash. Pick your poison.

Meanwhile, in Europe, the ECB is facing its own QE moment, with contagion easing last night on rumours of ECB bond buying. As The Economist’s Buttonwood put it so eloquently, the EU endgame now demands a solution:

If temporary solutions have failed, talk is now turning towards what the end game might prove to be. There are three main possibilities.

The first is default by Greece, an option which has long been priced into markets but only now seems to be gaining acceptance among policymakers. A Greek default cannot be a one-off; it may need the simultaneous injection of capital into Greek banks and further programmes for Ireland and Portugal, to limit contagion.

A second option would be a much larger programme of bond buying by the ECB. In theory, the bank has the authority to do this; whther it has the willingness to do this is another matter. Clearly the risk is that the ECB balance sheet may be compromised but that may be a better option than the alternative of euro colleapse, leaving the ECB as a central bank without a currency.

A third option would be a form of fiscal union, which many have argued all along was a necessary condition for a single currency. This might be achieved by the replacement of individual government bonds by a euro-zone bond, guaranteed by all governments. But this option raises a number of issues. Would all debt be guaranteed or only that portion below a certain limit, say 60% of GDP? If the latter, what about the countries with debts of more than 60%? Would the excess debt trade as if it were in default? And what would happen to new debts? Would new issuance also be guaranteed? What would happen to spendthrift governments, who were clearly not constrained by the Stability and Growth Pact?  Would creditor countries be given the right of fiscal control over debtors, i.e with budgets set in Brussels, not Athens or Rome? All this raises issues of democratic accountability, especially as voters in northern Europe may be no kore keen on such a deal than those in the south. and would a blanket guarantee of Italian and Spanish debt reduce the creditworthiness of the rest of Europe, notably France? These questions are all so tricky that it is hardly surprising European politicians haven’t wanted to face them. But events are moving at such a pace that they can no longer be ducked.

So, all tough. But ECB QE looks the easiest. Except, of course, that that comes with its own major headache. From Alphaville:

We won’t know if it really did happen, not until next week’s figures on Securities Markets Programme purchases. (Current total: €74bn)

But since there was plenty of rumour on Tuesday that the European Central Bank (via the Bank of Italy) intervened to buy Italian bonds from a terrified secondary market, mind if we point something out in the interim?

This is too big for the ECB. Too big, too dangerous, too much like monetisation of debt — even by the Bank’s collapsing standards. Possible? Yes. Sustainable? Not at all.

…After all, has anyone seen the trade volumes in Greek, Irish or Portuguese bond markets lately? The absolute capstone of the ECB’s failure was its becoming each country’s single biggest private creditor. Can’t beat markets into coming back, become the market. Case in point then.

But also a case in point — the vast size of the Italian bond market. Especially vast when you count the reams of auctions and issuance entering that market each month. Daily turnover in May of €12bn. Gross issuance in the third quarter of fresh two-, five- and 10-year bonds worth €31bn (not counting the reopening of previous issues). Refinancing needs in the next year of well over €300bn!

If the market really wants to fool itself that Italy would become a regular patient of the ECB, we’d really like to know how the Bank could possibly absorb those numbers. Even better, we’d love to enquire how it could sterilise them…

Oh, and we’d like to know where the ECB would go next from crossing the Rubicon of one of the world’s biggest government bond markets.

Anyone noticed the last few days’ the French spread to Bunds? It’s at its widest in the history of the eurozone…

And, I will add, God only knows what such a move does to the euro, with a rather ugly QE-off brewing between the world’s two largest economies.

What an incredible mess. Discretion remains the better part of valour.

David Llewellyn-Smith
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Comments

  1. Good read HnH – great to have you back.

    Is there such thing as jawboning on the downside…i.e. Fed talking up chances of loose monetary policy without actually wanting to do it…therefore hoping to kick start a buying session to stop this carnage?

  2. Torchwood1979

    “Either the Fed is going to have to detonate the world with an inflationary blowoff of QE3 or commodities must crash. Pick your poison.”

    Quote of the day!

    • Option 1 I suspect. QE3 is looking more likely given the reluctance of the US to deal with its multitude of problems. More of the same, kick the can a bit further………..

  3. 2006 Average Joe

    Wow look how rich we are! Gotta love all this wealth. Houses keep going up, shares keep going up. All you need to get rich is a mortgage; sittin’ on my couch getting rich while drinking beer is great!!!

    Shame about that loser I saw on TV saying we have too much debt. Oh well, his loss. Look how rich I am. Ha ha ha!!

  4. “The entire commodities complex went through the roof last night, even as equities lost their gains and ended in the red. Markets are now so attuned to the risk trade of a weak $US and emerging market inflation emanating from quantitative easing that the slightest hint of Fed dovishness sends the commodities complex nuts”

    I think it takes more than a reading of Fed tea leaves to discern Fed dovishness.

    You have to ask what is the common link between the Fed and the commodities market? is it the Fed’s primary dealers who play the commodities market with free cash and leaked info they get from the Fed?

  5. Montgomery Burns

    Regardless, Jackson Hole next month will be the next thing to watch and interpret …but I’m still not buying it (QE3).

  6. At each step on the inflation ladder we are surely climbing will we say every month ‘Well there was a bit more inflation but not much more than last moneth’ ?

  7. Commodities, what a con.

    If you are an average Joe you buy now and someone else has your cash pile. Meanwhile plenty of other things are getting cheaper bit by bit. When you want your cash pile back, wow, commodities are cheaper than when you bought.

    This is now a risky market being gamed by some very rich players using other people’s money. I’d be a bit patient and see if another crash comes, courtesy of Italy, as this site and ZeroHedge have foreseen for some time.

  8. the euro was down huge, then somebody came to the rescue…wonder who?

    wish i knew before hand – from 1.385 to 1.4+, hmmmmmm.

  9. The first quotation, the extract is copy-pasted twice, ie. search for “Participants also discussed the medium-term”.