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Analyzing the QE Meltdown, Ex-Ante


Correlation does not imply causation.


During the Jackson Hole symposium over Labor Day weekend, Columbia Professor Michael Woodford generated a lot of buzz by proposing that the Fed should look at a policy of targeting nominal GDP. This was a concept we had addressed a month prior. On July 31 in Bernanke's Astonishingly Good Idea, I posited that despite Bernanke previously dismissing it as an option, he was getting desperate and that a nominal GDP target was on the table.

I think we will start to hear more about a program along the lines of a nominal GDP (NGDP) target that is used to justify direct purchases of private assets.

The idea of targeting NGDP would be to place an extrapolated dollar amount on the output gap based on a specified growth rate and the Fed would commit to tightening or easing based on where nominal growth deviated from that trajectory going forward.

I didn't just lay out the possibility of a NGDP target initiative, but went a step further, framing the consequences and potential market reaction.
If the Fed did go nuts and drop money from the skies, they would be naïve if they thought it would not elicit a severe market response. The inflationary tail risk would likely manifest itself in an immediate collapse in the US dollar and a corresponding rise in long term interest rates.

This is the essence of ex ante analysis. I took a concept that was not discounted by the market but could become a real possibility given the state of the employment situation. Instead of finding a reason to be bullish because the Fed would be buying, which was the consensus view among market participants, I focused on why this would be bearish for a market that was already very long.

Last week in The Most Important Market No One Is Watching, I analyzed the price action following Friday's weak employment numbers as indicative of a market that was fighting for positioning and concluded that the result suggested the market was not concerned about the weak growth, but rather was preparing for the inflationary implications of QE III.
Since the miserable June NFP that only saw 45K jobs added, the contract (Dec now front month) has been confined to a range with the big pivot at 150-00 which is the same level that was tested in Thursday and Friday's intense volatility. This is not a random coincidence. The market is battling in here.

Friday the action in the yield curve told the whole story. The belly, 5-year and 7-year led the performance finishing better by 3bps and the 5-year/30-year spread finished 6bps steeper on the day. The steepening bias in the curve was a clear message that the bond market is preparing for a higher inflationary discount as the result of QE III.

Again, this is ex ante analysis applied. The casual observer looks at the weak data and 1.67% 10YR yield ex post and assumes the market remains fixated on what was a continuation of recessionary economic data. I took the approach that by virtue of the steepening curve, the market viewed the data as so weak that it would force Bernanke's hand into aggressive action, which translates into a higher inflation discount and thus higher long term interest rates.

Regardless of whether QE III is an implicit target of the output gap or an explicit one, the goal is the same. Bernanke knows employment won't come down with the output gap in place and it doesn't seem he will stop until he closes it. There is no doubt that the inflationary path to close the gap produces a steeper yield curve and higher long-term interest rates.

Coming into last week, the bond market was on alert and supply was coming, specifically in the long end with a 10YR and a 30YR auction right in front of Thursday's FOMC announcement. With the bond contract settling out the week below the critical 150-00 level, the risk was that the market wanted a test of the lower pivots I had also identified.
If the trading range that has confined the contract since June breaks to the downside, the pressure could be on. In addition to the crucial 150-00 level, I have lower pivots of 148-00 and 146-16. These levels should be respected if tested and I would not fade the move from these big pivots in either direction.

The 10YR auction on Wednesday was sloppy with weak participation from both direct and indirect bidders. The market was testing 148-00 already down 1.5 points on the week. But despite the poor auction, the contract found support and consolidated this lower pivot. After a considerable concession Thursday the market absorbed the 30YR auction fairly well and remained near the 148-00 level as we approached the FOMC witching hour.
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