An enormous amount of debate is currently occurring among financial market participants and central bank observers regarding the possible methods the Federal Reserve may pursue in an attempt to extricate itself from the ongoing quantitative easing policy of purchasing $85 billion a month in debt securities. The recent talk mostly focuses on the idea that markets would benefit from the Fed elucidating a detailed and actionable strategy that can serve as a framework to inform investors, corporate decision-makers, and financial intermediaries of what they can expect when central banks finally begin winding down the extraordinary monetary policy actions pursued since the 2008 financial crisis. At the core of this discussion, the fundamental issue of confidence in the competency of global central bankers becomes the salient factor as they begin to map an exit strategy that will ideally reduce the size of their growing balance sheets without causing major disruptions to economic growth or triggering a panic-inducing drop in asset prices. While the Fed may provide markets with such a plan, the more likely actual next policy action may end up being an expansion of the current program by increasing its monthly asset purchases.
Markets caught a sneak-preview of coming attractions regarding the dilemma the central bank faces when the stock and bond markets dropped sharply on May 9 amid rumors that the Wall Street Journal was preparing to publish an article by Washington-based chief economics correspondent Jon Hilsenrath reporting that Fed officials are planning the ways in which they will eventually end the latest iteration of quantitative easing. To illustrate the role Hilsenrath plays as a sort of unofficial spokesperson for FOMC policymakers, the description by Yale University professor and former Morgan Stanley-Asia chairman Stephen Roach of the reporter as "actually the chairman of the Fed" is appropriate because his stellar track record of curiously revealing potential policy actions ahead of official announcements leads many to believe he is the central bank's favored journalist for leaking information about internally debated proposals. On May 10, the rumored Hilsenrath "Fed Exit Strategy" article did appear in the WSJ after the markets were closed for the weekend.
The Hilsenrath article reveals an important piece of information about what Federal Reserve policymakers are currently trying to accomplish. Specifically, their intention is to send a signal to the financial markets that they are in control of the situation and have thoughtfully developed an approach to eventually bring their zero-interest rate and quantitative easing policies to a relatively painless resolution. This communications strategy is similar to the talk of Alan Greenspan engineering a "soft landing" in 2000 and Ben Bernanke's now-infamous declaration in March 2007 that "problems in the subprime market seems likely to be contained." The unmistakable message to the financial markets from the Fed is: "don't worry, we have this under control." The only problem with this approach is that - unlike their friend Hilsenrath's impeccable reporting - economic forces, major global events, and the cold, hard reality of financial market performance typically derail the Fed's best-laid plans and send them scurrying back to the relative comfort of their favored default position involving some manner of accommodative monetary policy.
Evidence that FOMC policymakers are likely to repeat this pattern can be found in the April 17 speech by St. Louis Fed President James Bullard when he expressed his belief that inflation is "too low" and the Fed has "room to maneuver" with the ability to increase asset purchases to "defend inflation from below." Bullard also commented that QE is a better tool for the Fed and other central banks to convince markets of their stated policy intentions than issuing statements and other forward guidance. This view aligns favorably with the April 4 actions by the Bank of Japan's Governor Haruhiko Kuroda and stands in contrast to European Central Bank President Mario Draghi's "whatever it takes" declaration in July 2012 that has thus far mostly remained more in the realm of rhetoric than in concrete monetary initiatives. Essentially, Bullard is advocating the Fed show the market the money and save the talking for later. As a current voting member of the FOMC, Bullard's suggestion of expanding QE asset purchases if inflation is judged to be "too low" would likely receive considerable support from dovish voting policymakers such as Daniel Tarullo, Sarah Bloom Raskin, Charles Evans, Eric Rosengren, Elizabeth Duke, Jeremy Stein, William Dudley, Janet Yellen, and, of course, Ben Bernanke. Incredibly, when placed in context with most of his colleagues on the FOMC James Bullard is considered by many to be a bit of a hawk, which makes his remarks about the potential for increasing QE asset purchases even more compelling.
The efficacy of QE is widely discussed among investors and the general public, yet seems to be afforded a stunning sort of acquiescence by much of the establishment media and financial market elite as the only viable prescription to the jobs perplex and moribund economic growth. Rarely do commentators or analysts in the mainstream financial press point out the dismal failures that have accompanied the iterations of quantitative easing in every nation in which it has been attempted. The fact is there is no single example in financial history of quantitative easing that was used to successfully revive an economy, return it to levels of economic growth and prosperity that preceded it, before bringing it to a conclusion and restoring conventional monetary policy. Admittedly, there is not a large data set to draw upon throughout the history of monetary policy, yet this point only goes to illustrate how unconventional and truly undesirable undertaking such measures were to previous generations of central bankers. On the most basic level, QE has enabled the federal government to continue financing trillions of dollars in annual deficits through the Federal Reserve's monthly purchases of U.S. Treasury securities. As a result of traditional risk-free rates in long-dated Treasury securities being driven to historic lows, investors and institutional money managers are enjoying the all-time highs in the Dow Jones Industrial Average (NYSEARCA:DIA), S&P 500 (NYSEARCA:SPY), and NASDAQ 100 (NASDAQ:QQQ) in the form of inflated 401K statements for Q1 2013. Thus far, the true net effect of the QE and ZIRP initiatives implemented since late-2008 seems to be to re-inflate asset prices to essentially bail-out banks and debtors, while simultaneously punishing savers, mispricing risk assets, and generally distorting the vital function of price discovery in the money markets. How any element of this trade-off benefits economic growth or contributes to significantly increasing workforce participation and compensation remains a mystery, yet the world's central banks continue down the same path with virtually identical results.
In order for QE asset purchases to be increased at some point during the second-half of 2013, a meaningful catalyst - or a confluence of multiple conditions - will necessarily have to set the stage for more vigorous policy action. The Fed has already identified benchmarks of an unemployment rate lowered to 6.5 percent and/or inflation exceeding its targeted 2.5 percent threshold as being triggers for it to begin winding-down its asset purchase program. At current levels of officially stated inflation and unemployment, neither condition seems imminent or even likely for the remainder of 2013, although a highly improbable 4-month string of consecutive 250K-plus NFP reports or sudden surge in the PCE price index would likely induce policymakers to enact more urgent QE curtailment measures if they feared a burst of inflation. The higher probability is that other events will overtake the nation's economic prospects and guide the Fed toward an expansion of QE in an attempt to maintain positive GDP prints, prevent the implosion of the current asset bubbles in equity and bond markets, keep the housing market from slipping back into another decline, and continue the financing of federal deficits in excess of $1 trillion a year.
The key metric FOMC policymakers seem to be relying on for guidance prior to their previous escalations of QE is the 5-year TIPS spread - the breakeven inflation rate - that was declining in each period leading up to the announcement of further asset purchases. Currently, the 5-year TIPS spread stands right at the 2 percent level, yet instances when it headed lower in combination with a greater rate of change led the Fed to augment its QE initiatives in the last several years. In nearly every instance, drops in the 5-year TIPS spread below 2 percent in the weeks leading up to FOMC meetings - and below 1.5 percent in earlier iterations of QE - have led to the Fed announcing enhancements of their accommodative policies. In addition to this vital metric, the Fed's actions have also mostly coincided with some arguably critical events affecting economic prospects such as: the emergence of the euro sovereign debt crisis in late 2010, the aftermath of the debt-ceiling standoff and subsequent Treasury credit rating downgrade in September 2011, and the uncertainty generated over tax and spending policies related to the fiscal cliff in late 2012. It is likely that a similar catalyst, combined with stagnant unemployment data and a declining 5-year TIPS spread, could be the spark that ignites another increase in monthly Fed asset purchases.
Several significant developments - in descending order from their highest probable outcomes - that have the potential to compel the Fed to consider increasing QE asset purchases by the end of Summer 2013 accompanied with several suggestions for investment positions that contain a high probability of generating gains from each catalyst and its aftermath:
1): Debt-ceiling increase and federal budget negotiations have strong potential to create economic uncertainty, intensified political acrimony, and significant disruptions to financial markets. As witnessed in the late-summer of 2011, these high-stakes battles over taxes, spending, and debt levels can breed chaos in the financial markets and dampen consumer sentiment at a crucial time of the year as businesses make Q4 2013 preparations. Looming in the background of this debt-ceiling deal is the possibility of another downgrade of U.S. Treasuries if a so-called "Grand Bargain" is not achieved, which would likely have significant consequences for Fed asset purchase policies.
Recommended Action Steps: (i.) As negotiations heat up: Buy S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX), VelocityShares VIX Short-Term ETN (NASDAQ:VIIX), ProShares UltraShort Dow30 ETF (NYSEARCA:DXD), ProShares UltraShort S&P 500 ETF (NYSEARCA:SDS); (ii.) Aftermath preceding next FOMC Meeting: Buy SPDR S&P 500 Trust ETF , PowerShares QQQ Trust ETF , SPDR Dow Jones Industrial Average ETF
2): Implementation of health insurance reform introduces a high level of uncertainty into labor markets in several meaningful ways, beginning for most businesses during the summer before open enrollment starts in Q4 2013. First, businesses will have to evaluate their benefits models and determine the impact on their compensation plans. Inevitably, some businesses will conclude that reducing a number of employees to part-time status and reduced hours will be the optimal method for dealing with federal health insurance mandates. Others may reduce headcount in an effort to stay below mandated thresholds. So-called "young invincibles" will be forced to dig into their own paychecks - or pockets - to pay monthly premiums to avoid tax penalties. In combination, any and all of these conditions will likely result in less disposable income for employees in either reduced hours, increased premium costs, or rising unemployment.
Recommended Action Steps: After consecutive monthly Labor Department releases of sub-100K NFP report, preceding next FOMC Meeting: Buy SPDR Dow Jones Industrial Average ETF , SPDR S&P 500 Trust ETF , PowerShares QQQ Trust ETF
3): Japan's stunning monetary policy is already having wide-ranging consequences on the global economy and in financial markets since it was announced on April 4. The breadth and ultimate results of this historic expansion of the Japanese money supply will begin to be understood in a more comprehensive context as the summer months unfold. The potential for the pursuit of full-blown "beggar thy neighbor" policies by other major central banks - including the Federal Reserve - to offset the impact on trade and exports is not to be underestimated. Corporate profits of U.S. companies with a significant market presence in Japan could see margins squeezed in coming quarters. Low-priced Japanese exports dumped on the U.S. market could have the dual effects of taking market share from competitors and stoking deflationary forces in a race to the bottom on price competition. Ultimately, the Japanese experiment could become a convenient political excuse to prompt the Treasury and Fed to pursue measures to weaken the dollar in the name of competitiveness.
4): Geopolitical tensions spilling into a larger conflict in sensitive regions like the Middle East. While always a concern to financial markets, the situation in Syria looks like it is rapidly approaching a defining moment for the West in terms of support and intervention. For Europe, the escalating violence in Libya poses considerable risks for oil imports and supply disruptions. Looming ominously like dark clouds on the horizon is the Iranian nuclear showdown where the "window of opportunity" for peaceful resolution is diminishing with each passing month. Any of these risks could contribute to headwinds that would potentially stall the economy and provoke further Fed accommodation.
Recommended Action Steps: As saber rattling and tensions escalate and military involvement becomes prominent in the public debate: Buy Lockheed Martin (NYSE:LMT), Raytheon Company (NYSE:RTN), The Boeing Company (NYSE:BA), ConocoPhillips (NYSE:COP), Valero Energy Corporation (NYSE:VLO), Halliburton Company (NYSE:HAL), Schlumberger Limited (NYSE:SLB), General Dynamics Corporation (NYSE:GD), The United States Oil ETF, LP (NYSEARCA:USO)
The ultimate consequence of the Fed's reactionary and incremental approach to its accommodative policies of QE and ZIRP is that economic growth has failed to gain traction while structural challenges in the labor markets continue to keep unemployment high and wage growth low. With the essentially open-ended nature of the current asset purchase program, the Fed's next move regarding QE will naturally be based on the performance of the economy and inflation expectations as other events develop. Unlike previous versions of QE, the Fed has not designated an official expiration date for their asset purchase program or specified a total amount it intends acquire. Ironically, both the equities and credit markets could benefit more from relatively negative economic news and statistics for the remainder of 2013 because of the likelihood that such information will provide the FOMC with valid reasons for pumping further liquidity into the system by expanding asset purchase programs. In the May 1 FOMC statement, policymakers left open the possibility that QE could be adjusted in either direction by writing that it is "prepared to increase or reduce the pace of its purchases." The Hilsenrath article in the WSJ about the Fed planning an exit from QE is necessary to send a reassuring message to financial markets that the FOMC is credible, powerful, and in command of this policy. Unfortunately, due to the limited real world central banking experience with QE that message is really only a smokescreen to give the Fed time before it once again expands its asset purchase program when the desired results fail to materialize.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.