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Bernanke's Date With Deflationary Destiny


If the market makes critical levels in the 10-year Treasury and US bond futures contract support, and fundamentals continue to deteriorate, we could see a significant rally.

At the December 12, 2012 FOMC meeting, the committee increased the previously announced QE III to include US Treasuries amounting to total stimulus of approximately $85 billion per month. At the same time they introduced economic "thresholds" targeting a 6.5% unemployment rate while not exceeding a 2.5% inflation rate. At the time I viewed this simultaneous raising of the inflation rate from 2.0% to 2.5% in order to bring down unemployment as a de facto nominal GDP target which was something Chairman Bernanke had said would be "reckless" at the previous April FOMC press conference.

My concern was this new "open-ended" QE would introduce the risk that if it didn't work the market would begin to lose faith that the Fed was relevant. In Bernanke Capitulates, Launches De Facto Nominal GDP Target, I concluded:

I would like to think Bernanke's intentions are pure, but I am also starting to wonder if his date with deflationary destiny is clouding his judgment. Either way it's pretty clear that he's making this up as he goes along.

As I have been saying since the Fed launched QE3 in September, the biggest risk in the markets today is a loss of confidence that Bernanke can hold this thing together. In my opinion there is a very large false sense of security that they know what they are doing and can indeed wield a wand to control asset prices. However, at the end of the day, this is still a confidence game. They can only do so if the markets believe that they can. If the markets lose faith, then all bets are off and the costs and unintended consequences could be severe.

This past Wednesday the Fed released the minutes from the subsequent January FOMC meeting that not only sounds like a serious case of QE III buyer's remorse but also suggests they are clearly making policy up as they go along:

However, many participants also expressed some concerns about potential costs and risks arising from further asset purchases.

Several participants discussed the possible complications that additional purchases could cause for the eventual withdrawal of policy accommodation, a few mentioned the prospect of inflationary risks, and some noted that further asset purchases could foster market behavior that could undermine financial stability.

Several participants noted that a very large portfolio of long-duration assets would, under certain circumstances, expose the Federal Reserve to significant capital losses when these holdings were unwound....

A few also raised concerns about the potential effects of further asset purchases on the functioning of particular financial markets....

In light of this discussion, the staff was asked for additional analysis ahead of future meetings to support the Committee's ongoing assessment of the asset purchase program.

There was one? FTN's Chris Low nicely summed up the apparent chaos in an email brief to clients:

The one word that best describes the January FOMC minutes is "confused." There were a lot of headline-worthy statements about ending QE early stemming from misgivings which one can't help but think should have been discussed and settled before the program was initiated last year, and certainly should have been resolved before QE doubled in size in December.

If you had any doubt about whether they knew what they were doing, well now you know. Nevertheless, the bond market didn't seem to care and went on consolidating the range around 143-00 that we have been watching for almost a month. In fact I'm beginning to think this is all a big joke and the bond market has just been humoring Bernanke into thinking he is in control.
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