For many months, the Fed had openly ignored what the market was signaling about future inflation expectations, either through 5Y,5Y forwards [9] or breakevens [10], instead opting to rely on such trivial and unreliable indicators as inflation surveys and beige book narratives. However, with the collapse in 10 Year yields back under 2% that has now changed. Here is what yesterday's FOMC minutes [11]had to say on this topic:
A couple of participants remarked on the apparent disparity between market-based measures of expected future U.S. short-term interest rates and projections for short-term rates based on surveys or based on the median of federal funds rate projections in the SEP. One participant noted that very low term premiums in market-based measures might explain at least some portion of this gap. Another possibility was that market-based measures might be assigning considerable weight to less favorable outcomes for the U.S. economy in which the federal funds rate would remain low for quite some time or fall back to very low levels in the future...
In other words, the Fed is suddenly at odds with what not only the market, but the Fed's favorite market-driven indicator of future inflation expectations is saying.
Does this lead the Fed to believe that it may be wrong? That remains to be seen but here is a take from BofA in its daily chart of the day:
[Recently] we argued that the drop in inflation breakevens adds another downside risk to inflation. Thus far, Fed officials have dismissed the dramatic drop. They note that surveys don’t show the same drop, and they argue that the drop may be technical. We are less sanguine. Looking at the current market, let’s take the extreme assumption that the inflation risk premia has dropped to zero — that is, investors are so certain about inflation that there is no insurance value in breakeven contracts. If the liquidity premium hasn’t changed, then current breakevens are consistent with 1.8% expected PCE inflation. In other words, either the market believes that even five years from now, the Fed will not achieve its target or the liquidity premia has jumped to 30bp.
And the chart in question, which while the Fed will never admit it, is terrifying the FOMC members as they have never heard a louder cry from the market that the Fed is "wrong, wrong, wrong" with inflation breakevens not only the lowest ince 7 years, but the lowest since the entire financial system was crashing!
[12]
Which may explain that other big surprise statement in yesterday's minutes, one which we also conveniently pointed out, when we revealed [13]that finally the Fed was admitting frontrunning of central banks is a key aspect of what moves markets:
In their discussion of financial market developments, participants observed that movements in asset prices over the intermeeting period appeared to have been importantly influenced by concerns about prospects for foreign economic growth and by associated expectations of monetary policy actions in Europe and Japan.
Why would the Fed make this admission? Simple: in its hubris and refusal to admit it may be wrong (as the market is implying), the Fed has had no choice but to state, tongue-in-cheek, that it is the market that is wrong and is no longer a fully efficient, discounting mechanism, and instead relies on frontrunning of monetary policy by other central banks, i.e., the BOJ current and ECB's imminent monetization of bonds, but also the Fed's ZIRP policy by implication. Of course, this is something we observed back in 2009 when the 200%+ "bull market" in stocks began, a bull market that has been entirely driven by frontrunning of global central banks liquidity injections which now amounts fo $11 trillion and rising at well over $1 trillion per year.
This also means that as Hilsenrath hinted earlier today, the Fed will be far less concerned about jarring the market from its frontrunning stupor in order to ramp forward inflation expectations, expectations which as BofA states ' suggest "the Fed will not achieve its target", i.e., the Fed will fail. Which to the Fed is equivalent to loss of credibility, and akin to suicide.
So will the Fed risk a few hundred points of S&P downside to regain credibility, and to avoid the embarrassing schism between what the market is signalling and what it is trying to achieve? Absolutely: just keep your eyes on the chart that "terrifies the Fed the most" - should the blue line above take out the Lehman lows, all bets are off.
