The following chart from Bank of America shows that with a few short hours ahead of the dangling strawman known as Bernanke's J-Hole address (now that Mario Draghi has more pressing issues to deal with elsewhere), expectations for QE3, in the form of what is actually priced in, just hit an all time high. So is, by implication, the potential for disappointment and that the petulant market, no longer caring about such trivia as fundamentals, technicals, newsflow or frankly anything except what the Chairsatan ate or what side of the bed Bill Dudley woke up on, will not get what it demands. It then begs the question: if the S&P is at 1400 with virtually all of QE3 priced in, what is the "fair value" if there is, gasp, no QE3 announced either today, in two weeks when the FOMC delivers it periodic oracular address to the plebs, or until the post-election FOMC meeting, which will take place on December 12, and just days ahead of the Fiscal Cliff arrival (which will certainly not be resolved by then)?
Some comments from Bank of America:
We anticipate a relatively dovish speech that signals a high probability of additional easing at the September FOMC meeting. But "easing" and QE3 are not synonymous. In our view, a change in the Fed's rate guidance is very likely, but Bernanke is probably not ready to preannounce QE3. Indeed, he is unlikely to front-run his Committee, so we would expect a speech that is long on historical defense of the Fed's easing to-date but short on details of any future actions. Given that the markets have priced in a high probability of QE3 (Chart of the Day), in our view that could be a disappointment.
A hawkish dove
In our view, more unconventional policy is just a matter of time. Thus, we expect Bernanke to emphasize three key points, without actually signaling the Fed's next steps. First, he is likely to underscore the bias statement in the minutes: if the economy does not improve substantively, the Fed will ease further. Second, he may discuss the Fed's options in more detail, building on some of the discussion already noted in the minutes. Third, he is likely to argue vigorously that unconventional policy is both necessary and effective.
The Bernanke Fed has not been shy about introducing new ways to use language or its balance sheet to stimulate the markets. However, we do not expect an outright signal of QE3. Keep in mind that "easing" and QE are not synonymous. When Fed policymakers signal that they are ready to ease, they mean not only changes in their balance sheet but also changes in their forward rate guidance and other language changes. Further, Bernanke will likely remind everyone that monetary policy is not a panacea - without naming names, he will likely point to the pressing need to deal with the fiscal cliff. He is also likely to note that unconventional policy comes with costs as well as benefits.
Rates market implications
In our view, the rates market could be disappointed by Bernanke's speech. Our model currently indicates that a greater than 85% chance of QE3 is priced into the market in the near term (3-4 months). This probability is at recent highs, indicating that the market is likely expecting some explicit signal of further QE by the Chairman at Jackson Hole - and the lack of one is likely to be taken as a disappointment by the market.
One could argue that selling nominal 10y Treasuries may be the way to position for a Bernanke disappointment trade. However, at 1.61%, we do not believe that nominal Treasury levels are extreme by any means. A return to risk aversion or disappointment on the economic data can lead 10y rates lower: just a month ago, 10-year Treasuries were at 1.39%. Selling 10y real rates, at close to all-time lows of -0.72%, offers more compelling risk-reward, in our opinion.
A significant portion of the rates market reaction will also depend on the reaction in risky assets. A risky asset sell-off triggered by the lack of a strong signal for QE could also mute the reaction of higher nominal rates, in our view. In this case, inflation expectations as priced in by TIPS breakevens should head lower. We recommend that investors tactically short 10y real rates and 10y TIPS breakevens to position for a disappointment from Chairman Bernanke.