Monetary Policy

The link between nominal interest rates, inflation breakevens, and stocks has changed; especially with regard the last few years' seemingly increased dependence on the Central Bank to keep an anti-deflationary floor on breakevens (or conversely the Bernanke Put under stocks). UBS' macro team, while humbly professing not to be experts in corporate earnings (which have been dismal) or balance sheet ratios (which are positive but have deteriorated in recent months) believe in a big picture macro perspective that we have been vociferously commenting on for a year or two now. Specifically, they have noticed a potentially curious link between the way the market interpreted monetary policy signals and the large cap stocks in the US: the breakeven inflation rate on 10yr TIPS has tracked the S&P 500 very closely this year. When the Fed is perceived to be successful in stimulating the economy, stocks benefit and breakevens also rise. When the Fed’s potency is called into question, stocks fade and breakevens decline. As official policy rates remain frozen near zero (and remain so for the foreseeable futures), nominal Treasury rates have lost their 'signal' as UBS agrees with the point we have been making for a long time: central bankers and politicians, not economic fundamentals and inflation expectations, currently drive the nominal rate and equity markets.

We have desperately tried to explain the sheer idiocy of the circular argument of the Fed 'attemping' to stimulate fiscal policy by enacting an overly permissive monetary policy, having failed miserably time after time. Perhaps the 'simplistic' argumentation of Diapason's Sean Corrigan will succeed where we have failed (although we are not holding our breath) as ne hotes, in true Orwellian fashion that 'Weakness is Strength' and "Once bailed out, always bailed out seems to be the guiding inference. Meantime, close your eyes and pray."

We have critically examined the question of whether the stock market 'discounts' anything on several previous occasions. The question was for instance raised in the context of what happened in the second half of 2007. Surely by October 2007 it must have been crystal clear even to people with the intellectual capacity of a lamp post and the attention span of a fly that something was greatly amiss in the mortgage credit market. Then, just as now, both the ECB and the Fed had begun to take emergency measures to keep the banking system from keeling over in August. This brings to mind the 'potent directors fallacy' which is the belief held by investors that someone – either the monetary authority, the treasury department, or a consortium of bankers, or nowadays e.g. the government of China – will come to their rescue when the market begins to fall. 'They' won't allow the market to decline!' 'They' won't allow a recession to occur!' 'They can't let the market go down in an election year!' All of these are often heard phrases. This brings us to today's markets. Nowadays, traders are not only not attempting to 'discount' anything, they are investing with their eyes firmly fixed on the rear-view mirror – they effectively trade on yesterday's news.

Another thesis regarding the housing market’s future path is that of a bounce and slog market. The theory focuses on the negative equity home owners and also the low inventory on the current market. This view point actually holds some solid ground. As of last count, there are over 11 million negative equity home owners in the US. This data is usually put out quarterly but with the stronger home price movement this summer, many will move out of the negative equity position. The theory proposes that many are not selling today simply because they cannot without bringing cash to the table. Out of the 11 million underwater home owners, how many would like to sell but simply do not because they would actually lose money on their sale? This is an interesting perspective on the underwater segment of the market. Yet the outcome is probably not as clean cut as one would expect.

The empirical data is in. And it turns out that as we have been suggesting for a very long time — yes, shock horror — helicopter dropping cash onto the financial sector does disproportionately favour the rich. Here are four simple questions to the venerable Bank of England (just as applicable to any and every Central Banker); and sadly, we expect to see the announcement of more quantitative easing to the financial sector long before we expect to see answers to any of these questions.

The odds of Fed easing at the September FOMC meeting seem close to 50-50 (with both sides vehemently talking their books - Fed officials and equity managers alike). Recent data has been a bit better: payrolls, claims, retail sales, and industrial production. As UBS' Drew Matus notes, other factors that will play a role include the ISM report, claims reports, and 'fiscal cliff'-related events. However, the primary determinant will be the upcoming August payroll report. The chart below ignores these other factors and offers up the odds of further easing in September based on the base case that Bernanke’s primary concern is the state of the US labor market. July’s 8.3% unemployment rate and payroll gain of 163k put current odds of further easing at 45%.

"It is rather amazing that a 2.8% yield on the long bond couldn't do the trick. By hook or by nook, it looks like the Fed is going to make an attempt to drive the rate down even further — but if that was the answer, wouldn't Switzerland, Japan and Germany be in major economic booms right now seeing as how low their 30-year bond yields are? Monetary policy in the U.S.A. is not the problem, so it is doubtful that it will be the solution. It all boils down to fiscal and regulatory policy and how the government can part the clouds of uncertainty — the Fed may be able at the margin to cushion the blow, but that's about it."

There is a frequent tendency to over state the importance of the Fed and its policies and ignore the primary fundamentals driving the gold market which are what we have long termed the ‘MSGM’ fundamentals. As long as the MSGM fundamentals remain sound than there is little risk of gold and silver’s bull markets ending. What we term MSGM stands for macroeconomic, systemic, geopolitical and monetary risks. The precious metals medium and long term fundamentals remain bullish due to still significant macroeconomic, systemic, monetary and geopolitical risks. We caution that gold could see another sharp selloff and again test the support at €1,200/oz and $1,550/oz. If we get a sharp selloff in stock markets in the traditionally weak ‘Fall’ period, gold could also fall in the short term as speculators, hedge funds etc . liquidate positions en masse. To conclude, always keep an eye on the MSGM and fade the day to day noise in the markets.

The conditions are dramatically different from the first two QE initiatives in regards to Pre-Conditions or available flexibility to undertake an asset raising initiative.

Moments ago, the FOMC members formalized their opinion on where inflation is heading: "Most members continued to anticipate that, with longer-term inflation expectations stable and the existing slack in resource utilization being taken up very gradually, inflation would run over the medium term at a rate at or below the Committee’s objective of 2 percent." The only conclusion one can derive from this is that since the perpetually wrong FOMC committee, which has never accurately predicted any one thing in its entire history, sees little to no inflation, inflation is most likely about to soar. A convenient independent confirmation of this assumption comes from none other than bond manager PIMCO which moments ago announce that it was adding to its gold holdings "on inflation concerns...as it bets that global inflation rates will pick up over the next three to five years." Specifically, "The Pimco Commodity Real Return Strategy Fund, which has about $20 billion in assets, has increased its gold holdings to 11.5% of total assets recently, from 10.5% two months ago, and has been adding to the position when gold prices dipped toward $1,500 a troy ounce, says Nic Johnson, the fund's co-portfolio manager." And with global asset managers allocating about 1% of their AUM to the precious metal, should the majority of them copycat PIMCO in this move, then gold would cross the psychological $2,000 barrier in minutes. The irony is that for a bond manager, which Pimco just happens to be the biggest in the world, inflation is your worst friend. So acknowledging its imminent creep, is hardly "talking one's book."

The thoughts of the FOMC from a mere three weeks ago - before a 30bps rise in 10Y yields (40bps in 30Y), 5% rise in the NASDAQ, 8.5% rise in AAPL, and 85bps compression in Spanish bond spreads - are out. It appears little has changed in their muddle-through, always at-the-ready, wish-it-were-better view of the world. Via Bloomberg,

• *FOMC PARTICIPANTS SAW ECONOMY DECELERATING AFTER JUNE MEETING
• *MANY FOMC PARTICIPANTS SAID MANUFACTURING WAS SLOW OR FALLING
• *FOMC PARTICIPANTS DISCUSSED QE, EXTENDING 2014 FORECAST ON RATE
• *FED STAFF SAID MARKETS HAVE LARGE CAPACITY TO HANDLE MORE QE
• *MANY FOMC PARTICIPANTS SAW NEW QE AS BOLSTERING U.S. RECOVERY
• *MANY ON FOMC FAVORED EASING SOON IF NO SUSTAINED GROWTH PICKUP

Translation: "Many on FOMC want the S&P at all time highs without actually doing any QE, ever, because that will mean the Fed is officially out of bullets"

Some in the markets think that the Fed effectively targets equity prices, meaning that to predict Fed policy, one merely needs to track the US stock market. There is a curious circularity to this view, however: the Fed will not launch QE3 so long as stock prices are high, yet the stock market is high because it anticipates QE3. BofAML's chart-of-the-day is intrguingly similar to our 'QE Hopeyness' chart as it shows that stock and bond prices have decoupled since the summer, as QE3 expectations overwhelmed the weaker macroeconomic data to buoy equities. Now that recent data have improved, yields have risen - but so too have stocks. This "heads I win, tails you lose" aspect of stock prices rising regardless of the macro backdrop, BofAML believes, makes them a far less useful signal for Fed officials. Moreover, it creates the risk that the equity market could sell off after the 12-13 September FOMC meeting if the Fed disappoints. Right now, however, we are in an anti-Goldilocks period in which the data are too hot for clear-cut Fed easing, but too cold to support a sustained rebound — anything but "just right".

European bourses are down at the North American crossover, all ten sectors in the red, on thin volumes and a distinct lack of data and news flow from the EU and the UK. The risk-off tone in part attributed to the much wider than expected Japanese trade deficit for July, whose exports also fell the most in six months, raising investor concern once again that Asian economy as a whole is stalling. Elsewhere, investor caution over the Greek debt crisis is once again mounting, as EU’s Juncker visits Athens today to meet with the Greek PM Samaras. Overnight it was reported that Greece would present EUR 13.5bln in budget cuts today, higher than the previous EUR 11.5bln, and whilst the country is not asking for more money, Samaras might request more time to implement them. Lawmakers in Netherlands remain critical of providing more aid for the country and continue to push for more reforms, such as spending cuts and privatization, with the Dutch Finance Minister de Jaeger commenting earlier that it is not a good idea for Greece to get more time.

Hopes that today may finally see an increase in trading volatility and volume following yesterday's reversal session will likely be dashed as the event wasteland on the horizon continues for the third day in a row. As DB explains, the FOMC meeting minutes and Juncker’s visit to Athens are likely the two main sources for key headlines today. While backward looking and certainly predating Lockhart's hawkish comments from yesterday, the FOMC minutes today are expected to shed further light on the kind of policy currently under consideration and the economic conditions required before easing is warranted. One thing that will not be discussed is the circularity of launching more QE even as gas prices have never been higher on this day in history, soy and corn are back at all time highs, and the market trading at multi-year highs. As repeatedly explained before, the option for the FOMC include pushing out the targeted exit date for fed funds, providing “exit guidance” on balance sheet measures (i.e. asset sales), various mixes of additional balance sheet expansion (including the possibility of an open-ended QE program) and  cutting interest on reserves. It is virtually certain that none of these will be enacted at the Jackson Hole meeting in one week, 2 months ahead of the presidential election, but hope springs eternal.

The timing of the report is interesting. Will it influence Bernanke? Maybe.