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The end of QE2 is coming up fast by the end of June. As the way it's been since the '08 crisis, Fed action is by far the single biggest factor driving the market, trumping all fundamentals, technicals, and geologicals. So naturally, the favorite pastime of the market is to guess whether QE2 will be promptly followed by QE3. Getting this answer right would put you on the right side of easily the biggest trade of the year.

I'll sum up a few well-known reasons why QE3 is not happening, at least not right on the heels of QE2.

  • The economy has been steadily, though slowly, improving. Permabears would protest. But all the underlying risks aside, I don't think one can make a point that it is falling off a cliff.

  • Commodities inflation has been causing havoc in world politics and social stability, and poses a real risk of strangling the U.S. recovery. The Fed may have easily built a psychological defense against feeling guilty about starving the poor; but it's much harder for them to ignore the domestic deflationary risk of sustained high commodity prices.

  • Supply shock from Japanese quake/tsunami/nuclear-disaster further increases inflation pressure and squeezes corporate profit margins.

  • Numerous regional Fed presidents have come out with surprisingly hawkish tones against further QE; some even spoke about considering ending QE2 early, or a single mandate for the Fed. Wow, how refreshing. Fed hawks, if there was ever such a species since Volcker, they have never been so vocal. This is highly unusual. Fed opinion is what matters ultimately.

  • This view has been supported by market actions and media/blogosphere chatter in the past week or two. The USD is rebounding, commodities (including precious) are softening, bonds are retreating. Each of them may have their own excuses, depending on whom you ask. But the quiet correlation has been very telling nevertheless.

Quantitatively speaking

Furthermore, I think I have uncovered something more quantitative about Fed thinking. The chart below shows the 5-year inflation expectation (InflExp) derived from TIPS [Treasury inflation-protected securities] and CMT [constant maturity Treasury] yields, TIPS yield, overnight Fed Fund rates, and month-over-month CPI-U change since early 2003. Focus on the 5-year InflExp (red line).

Click to enlarge:

Look at the timing of the tightening/easing cycle in 2004-2006 and think back about the timing of QE1, QE Lite, and QE2. It clearly shows two values in InflExp that triggers the Fed into action:

  1. If InflExp falls below 1.3%, ease -- either lower rates or print.

  2. If InflExp goes above 2.5, tighten -- either raise rates or withdraw money.

  3. The Fed's comfort zone is 2.0-2.5.

In fact, we can attach a specific number to the infamous Bernanke Put strike: InflExp=1.3.

Now, I don't know if the Fed looks at the 5-year InflExp as opposed to 1-year. And I'm not saying anything about the validity of this particular measure of InflExp. But it's quite evident that the market InflExp factors heavily, though maybe indirectly, in Fed thinking -- as opposed to MoM CPI-U [US Consumer Price Index - All Urban Consumers] change, which is pretty much irrelevant (to anything).

And we're sitting right smack in the middle of the Fed's comfort zone. There is no way the doves could make a case for QE3 or QE2+. Granted, there's still three months before QE2 ends, a long time for today's black-swan-lake of a world. If, for whatever reason, the red line turns downward and approaches the Bernanke Put strike, I'll write another article about it.

How to play it

How to frontrun the Fed if you believe this? It's generally the classic risk-off trade, even though the underlying driver has little to do with risk-on/off.

Short or at least go flat on all commodities, including precious. If you still believe the driver for commodities is anything other than excessive speculative hot money, nothing I say here is of any value to you. Move on.
Short or at least go flat on equities. Sure, equities has been the unstoppable bull. Again, if you still believe this is driven by anything fundamental, move on. I believe equities, as commodities, are mostly driven by excessive money. When the drug dealer leaves town, withdrawal will hurt.

Go long USD or at least go flat on most other currencies (except the Swiss Franc), especially the commodity ones. No, the lack of QE3 won't be enough to restore the Fed's credibility. But it is a step in the right direction, and will be treated as such by the market. Moreover, Japanese are printing like crazy and Europeans may soon have to restart printing due to the sad old stories of Portugal, Ireland, Greece, and soon the glossed-over story of Spain.

Bonds may be a little tricky. Usually bonds should do well during tightening, or in a risk-off environment if you may. But the end of QE2 also means the biggest buyer for the last half year goes MIA. I'll be watching this space closely.

The duration of this trade is up to three months. But it could start early, especially this week as ten regional Fed chair speeches are scheduled. And Bernanke's 4/23 scheduled press conf will no doubt be a decider.

I'm still long-term bullish on precious. But I need to survive the short-term first.

Disclosure: I am short GLD, SPY, USO, UUP

Source: No QE3: Here's Your Chance to Frontrun the Fed, Again