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The Unintended Consequence of Open-Ended QE


A look at the rising risk of actual volatility.

MINYANVILLE ORIGINAL This past week the market traded counter to the reflationary trend that had been defined by QE positioning. The yield curve flattened, inflation breakeven spreads narrowed, the dollar rallied, oil and stocks both pulled back. The bond contract traded right back to the influential 150-00 pivot level I have been watching, which provided stiff resistance despite a slew of weaker than expected economic data. Since the Fed announced QE the volatility in the bond market has been intense, and I think this is indicative of how it will trade for months to come. Last week I discussed the collapse of implied volatility in the bond market. This week I will discuss the rising risk of actual volatility.

When I wrote Analyzing the QE Meltdown, Ex Ante I had sent the link in an email to a few friends who are in the business of investing capital with the following comment:
Now the key going forward is the tradeoff between inflation, employment, and interest rates. The market has sounded the alarm and now wants to know this question. What level of inflation is Ben Bernanke willing to accept to bring down unemployment? Until that is defined, the bond market , or more specifically, the long end of the curve, is left to fend for itself. That should continue to foster a volatile environment that will be tricky to navigate.

When Bernanke left QE open-ended with no defined economic objective, he left it to the market to interpret what data trends would produce more or less easing going forward. In fact it's possible that each tier-one data point could now be traded as if it was an unpredictable FOMC announcement. The initial reaction to open-ended QE has been a reduction in implied volatility, but an unintended consequence is that it may trigger higher actual volatility.
No positions in stocks mentioned.

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