A Single QE Indicator? Not So Much...
Yesterday, Bank of America put out a report highlighting that the best QE indicators are the 10-year and 5-year breakeven rates. For those who don't know, the breakeven rate is equivalent to market expectations of inflation. For the 10-year breakeven rate, you would subtract the inflation-protected (TIPS) 10-year yield from the nominal 10-year yield. When this is positive, as it is now, traders are expecting positive inflation, whereas when the rate goes negative traders are expecting deflation. As Bernanke is one of the best scholars of the Great Depression and is also an expert on the Japanese collapse, he knows the destructive power of deflation. Thus, when he sees deflationary pressures, or even disinflationary pressures rising, he may be prompted to print.
As you can see here, the Fed printed every time the 5-year breakeven rate crossed below 1.5%. Below, you can see that the same pattern occurred on the 10-year breakeven at 1.75%. It's not always that correlation equates to causation and sometimes patterns occur for no reason at all. So, is this the be-all end-all QE indicator? I don't think so...
First of all, if Chairman Bernanke was making his policy decisions solely based on market expectations of inflation, I would be worried. For example, the Fed embarked on its non-traditional monetary policies as the employment situation worsened. Each time the Fed printed, Non-Farm Payroll growth was at or below 0, meaning that job growth was stalling. Also, ADP private sector job growth showed a slowdown in private sector employment. In addition, the S&P 500 is 72% correlated to both the 10-year and 5-year breakevens going back to the beginning of 2005, meaning that it may be that the Chairman sees stock prices falling and prints, and the pattern in bonds is just a correlation effect, not causation. Each time the S&P 500 crossed below 1100 into the 1050-1100 range, the Fed printed. Even further, the two bonds are about -84.5% correlated to the VIX, meaning as market volatility rises, the breakeven rates fall, and the Fed prints. Whenever the VIX broke through 39, the Fed printed. Once again, this is a question of chicken and the egg? Which is the cause and which is the correlation? Personally, it truly does not matter because we know (well, at least hope) that the Fed is looking at more than one indicator when embarking on QE, and so predicting QE based on one indicator solely seems unreasonable and potentially just plain stupid.
A better way to predict QE would be to take a broad view of the economy. Unemployment figures, inflation metrics, and yes, asset prices too, because they all matter in the scope of the Fed's decisions. The reason why the Fed went with Operation Twist instead of full-blown QE last year was because of politics, so it may be also prudent to consider the political climate when making QE predictions.
So the question is, is QE3 coming or some other form of balance sheet expansion? These indicators are currently saying that the chances are higher than they were back in March, but we are nowhere near the crisis mentality in the markets to prompt the Fed to act: with oil prices falling and other commodities following suit, stocks losing ground, volatility rising, and inflation expectations falling, the chances are higher now. It seems that a further deterioration of the medium-term outlook of the economy to prompt the Fed to act, but the chances are rising ever so slowly.
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Tags: Federal Reserve