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QE Not Working Out as Planned, but Hey, I'm Just a Caveman Economist


The Fed and pundits are declaring QE victory based on employment and rising stock prices, but correlation does not mean causation.

I subscribe neither to the stock or flow theory. I have put forth that it is the QE (inflation) discount that governs bond yields and asset prices. The QE influence was found in the real interest rate that was a function of the inflation premium. Real rates dragged nominal yields lower as the inflation premium rose and is now pushing them higher as that inflation premium is being removed.

Real 10-Year Vs. 10-Year Inflation Breakeven

As I concluded in The QE Carry Trade is Imploding Right Under Everyone's Noses:

It's happening right under everyone's noses, but they can't see it because they don't understand how QE impacts market prices. They are focused on the flow of QE and not the discount. It's not the flow of purchases that affects risk assets, it's the inflation discount embedded in the yield curve. The US economy and capital markets have been reliant on the Fed successfully engineering a negative real interest rate regime. By reneging on their commitment to inflation, the negative real rate regime is imploding -- and with it, the QE carry trade they engineered.

This is a huge deal because this meltdown is happening in the face of decelerating growth and there is not a lot of room for error. The Fed's QE is helpless if it is unable to generate inflation, and I believe that is what is driving this violent unwind. In March I warned what would happen once the market took matters into its own hands in Quantitative Easing: The Greatest Con Ever Sold:

When interest rates rise into decelerating nominal GDP, "accidents" can happen. If the 10-year is topping and we get a swift move toward 2.5-3.0% as nominal GDP is decelerating then the stock market that everyone loves to own could suddenly become very risky.

Why should we assume that the Fed has been successful in lowering interest rates, or that they would be able to hold them down if the market were ready to turn? Buying $5 billion/day in a market that trades $500 billion isn't going to cut it.

There is no denying the improving employment picture despite the quality of jobs being substandard. However there is also no denying that the growth in consumption is decelerating to the lowest levels of the recovery. Not only is consumption the largest component to GDP, the growth rate is highly correlated. The PCE YoY growth rate in Q4 averaged 3.5% and nominal GDP registered 3.5%. In Q1 PCE averaged 3.1% growth and nominal GDP grew 3.3%. Thus far the Q2 run rate for PCE is 2.65% potentially pointing to a sub 3.0% nominal growth rate. As a comp, when the Fed ended QE II in June 2011 the growth rate in consumption was 5.3%.

PCE YoY – 10-Year Yield Vs. PCE Deflator

When gauging the growth rate in consumption in the face of rising interest rates, you can see we are entering a zone where the cost of money becomes restrictive. When taking the 10-year less the PCE deflator, there is even a greater deviation from the falling regression line approaching two standard deviations in real terms.
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