Michael Gayed: Did Federal Reserve Just Admit QE Mistake Was Deflationary?
Fed minutes seem to suggest the Fed wants out of QE not because of QE itself, but because it was deflationary to begin with.
-- Robert Half
One of the largest and most unusual characteristics of last year's market movement was the complete collapse of inflation expectations in the face of the Fed (then) pumping $85 billion/month into the bond market. This was the first iteration of quantitative easing ever that did not result in any kind of commensurate rise in reflation. It's why commodities (represented by the PowerShares DB Com Index Tracking Fund ETF (NYSEARCA:DBC)) and emerging markets (represented by the iShares MSCI Emerging Markets Index ETF (NYSEARCA:EEM)), those areas that benefit from reflation, fell so hard relative to the S&P 500 (INDEXSP:.INX) which completely disregarded the deflation pulse. The reflation disconnect, as I have often called it, really is an undeniable fact, and one that perhaps the Fed became attuned to.
Consider that one of the things the minutes referenced was the idea that QE's benefits were "waning." That essentially means the Fed has started to view quantitative easing as nearing a point of ineffectiveness. If we take a step back, it's easy to understand that with ineffective monetary policy comes deflationary pressure. After all, if stimulus were effective and its effects were not waning, the Fed would likely achieve its inflation target. The fact that the Fed acknowledged this explicitly suggests that quantitative easing was actually the source of last year's deflation pulse, and intermarket distortion. By extension, then, the tapering of QE should reverse it.
This appears to be happening. With the Fed pulling back on bond buying, inflation expectations are, oddly enough, starting to rise.
Take a look below at the price ratio of the iShares Barclays TIPS Bond Fund ETF (NYSEARCA:TIP) relative to the iShares Barclays 7-10 Year Treasury Bond Fund ETF (NYSEARCA:IEF). As a reminder, a rising price ratio means the numerator/TIP is outperforming (up more/down less) the denominator/IEF.
This is one way of tracking inflation expectations. Note that the ratio is rising in a pretty significant way the last few days, presumably due to jobs-data hope and urgency being forced by the Fed with the threat of an end to quantitative easing. Historically, this tends to be the kind of condition that is supportive of risk assets. The Great Convergence between US stocks and inflation expectations appears to be underway. The real major convergence, though, remains the gap between emerging market stocks and US markets.
If this continues, the dollar (respresented by the PowerShares DB US Dollar Index Bullish (NYSEARCA:UUP)) may have a hard time rallying, and foreign-denominated assets could get a strong bid. I have noted in my studies that there does seem to be a strong link between emerging market outperformance and inflation expectations. So far the relationship in 2014 has not held, but there is a very real possibility that it re-asserts in the coming weeks. For US stocks, the supportive elements remain in place. For bonds? Hard to see yields drop substantially unless Janet Yellen shocks markets by adding to stimulus. However, I suspect this is exactly what the Fed wants -- higher inflation expectations, and urgency.
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