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The Unintended Consequence of Open-Ended QE


A look at the rising risk of actual volatility.

There is no more important economic statistic than the monthly employment report, and perhaps the second most important release is the ISM manufacturing report. This week we will get both numbers which are the first since the Fed launched QE III. There are two important questions investors are facing that the market will be answering with each economic release.

What is the current bond market discount for how much QE is forthcoming?

How will the incoming data adjust this discount?

By launching an open-ended QE, Bernanke made a very big change in how monetary policy would be conducted from his previous regime. Bernanke has been a big advocate of opening up the communication from the Fed in an attempt to make monetary policy more effective. In doing this he has lulled the markets into being used to him telegraphing every move. However with QE III being open-ended, the market will be returning to an era where the future path of monetary policy had to be interpreted from each data release. If you could define Bernanke's tenure, it would be in the certainty of monetary policy. But with open-ended QE, that era has ended.

For example, what is the level of non-farm payrolls that will elicit a reduction in the unlimited QE discount? What if private payrolls exceed 150k for successive months? What happens when jobless claims drop below 350k? What about ADP? Then there are employment leading indicators where you have numerous data points that could be extrapolated into employment trends. You have ISM manufacturing, housing and retail sales, and within these statistics you have the ISM inventory to sales ratio, construction permits, and consumer spending that will all be indicative of employment trends. The market will calibrate the QE discount on each of these releases, and just as the recovery has been volatile, so too will be the reaction to the data. For years Bernanke made economic data largely irrelevant, but with open-ended QE III, he now makes the data extremely significant.
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