Mercedes Ben

Includes: DIA, QQQ, SPY
by: Michael Ashton

On Wednesday, Fox News was showing live video of police in Los Angeles chasing bank robbers escaping in an SUV. The bank robbers began to throw cash out the window (see picture below), apparently hoping to have the streets behind them blocked by the scores of people scooping up free money.

It didn’t work, and the robbers were apprehended. Of course, it didn’t work – that money isn’t worth what it used to be, and anyway the Federal Reserve today was on schedule to throw a heck of a lot more money than that out the window.

And throw they did – in fact, in recognition of the similarity between the money-flinging bandits and the Federal Reserve chief, I move that we retire “Helicopter Ben” as a moniker in favor of “Mercedes Ben,” which anyway has a better ring to it (and a built-in song). Interestingly, despite all indications – quite deafening indications to anyone who has listened to Fedspeak for any length of time – that the Fed was planning another dose of QE, a surprising number of investors were evidently surprised. There were no bad bets from the long side today: stocks launched higher on the news, gaining 1.6% to four-and-a-half-year highs.

The DJ-UBS commodity index rose 0.7% to a one-year high (up 18% since mid-June). Treasuries gained (although it is hard to fathom exactly why, since the Fed will be buying mortgages, not Treasuries), with the 10-year note rallying 4bps to 1.72%; but TIPS launched higher with 10-year yields falling 13bps (to an all-time low of -0.76%) and the 5-year TIPS dropping 16.5bps to -1.62%. This sent breakevens sharply wider, with 10-year breakevens up 9bps on the day to 2.48%, the highest since last May. The all-time high for 10-year breakevens is around 2.78%, which is still a fair bit away; but, by the same token, 10-year breakevens touched 0% in late 2008, had lows of 1.52% in 2010 and 1.71% in 2011, and are up 41bps since July 26 (see Chart, source Bloomberg).

Meanwhile, 5y inflation, 5 years forward, extracted from inflation swaps quotes (which is the proper way to do it, rather than looking at a pair of idiosyncratic bond breakevens), is at 2.98%, threatening to break the 3% level for the first time (other than during a quick spike in March) since last year. And that’s as the Fed starts QE3.

One thing is sure, and that’s that at least one investor out there is very, very unhappy today. That’s because over the last few days, someone bought at least $2 billion in 0% zero coupon inflation floors, in 5-year and 10-year tenors, in the interbank market over the last few days (and who knows if more traded directly on a dealer-to-dealer basis). A 5-year 0% zero coupon inflation floor will pay off only if there is net deflation over the next 5 years; for the 10-year 0% floor, the deflation will have to persist for a full decade.

These floors are analogous to what is found in TIPS themselves, so there is a chance that the dealer buying these floors is preparing a TIPS-like inflation-linked bond issuance buying them on behalf of a punter (these days, since banks can’t engage in proprietary trading, it is very unlikely this is a bank bet). The interbank market is anonymous except to the actual counterparties who consummate a trade (and regulators, of course), so we are left to wonder whether there is some plan here or whether some investor just made a very big bet at exactly the wrong time.

So what was so surprising about the Fed throwing money out the window? The FOMC statement said, in relevant part:

The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective.

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.

The Evans Rule is no longer soft, as it has been since June. It is still non-parametric, but it is explicit. The Fed will keep easing (in MBS, “additional asset purchases,” and using “other policy tools”) until “the outlook for the labor market” improves “in a context of price stability.”

Bernanke said in his post-meeting presser that the Fed will be following a “qualitative” approach to easing, and said that if the economy becomes weaker, “we’ll provide more support.” More support? More support? They’re going to run out of things to buy. He said the Fed won’t be “premature” in removing accommodation (translation: they’ll keep programs in place too long, rather than risk being too brief), a determination echoed elsewhere in the statement:

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.

Have no fear, however: Mercedes Ben said comfortingly that the Fed has the “tools and the willpower” to keep inflation low. Because, you know, if you just have enough willpower everything will work out just fine.

The purchase of mortgages as opposed to Treasuries is most likely not primarily driven by a desire to lower mortgage rates, which are already absurdly low anyway. I suspect that, in a rare moment of thinking ahead, the Fed realized that since there is already something of a concern about a shortage of Treasury collateral with which to margin derivatives trades, leading to a new Wall Street business “transforming” collateral, it will be less disruptive on market function to buy non-Treasury collateral.

I had expected, as I wrote back at the end of August, that the Fed would do QE “perhaps in mortgages instead of or in addition to Treasuries,” and might change the formulation of the ‘extended low rates’ promise (which was extended to 2015, but that doesn’t mean much now) to be a hard formulation of the Evans Rule. We didn’t get the hard formulation of the Evans Rule, but as I say, it’s explicit.

It appears that we have not yet gotten a cut in the Interest on Excess Reserves (IOER), which would probably be the most-potent easing measure. The IOER is technically not decided by the full Federal Open Market Committee (FOMC), but by the Board of Governors only – that is, excluding the regional Federal Reserve Presidents. However, politically speaking, if the BOG were to cut IOER without the tacit agreement of the rest of the FOMC, it would make the next meeting a mite testy (plus, there is the risk of running out of alphabet letters).

So, lump the IOER cut into the “other policy tools” bucket.

The positive response in markets to what was a fairly obvious policy move – although evidently not obvious to all – suggests that more is ahead. That is less clear with equities, which have to face considerably headwinds of European volatility yet, but I would expect breakevens and commodities to continue to do quite well going forward.

Tomorrow, the CPI will be released. The consensus call is for a +0.6% rise in headline prices and +0.2% on core inflation. That will take the year/year change in headline CPI from 1.4% up to 1.7%. Core inflation is expected to fall from 2.1% to 2.0% y/y, which indicates that Street economists are expecting a “soft” 0.2% (one that rounds up to that figure) of 0.16% or 0.18%, since anything higher than that would cause the y/y change to round up to 2.1% and appear unchanged. If we do not get the round-down to 2.0%, we probably aren’t going to see it for a while. The next four months that will slide off the year-on-year comparison for core inflation are all +0.17% or less.

Thus, August is likely to be a local low, although given the big downside surprise (for quirky reasons) last month, and given that the median CPI is still at 2.3%, I frankly think there’s a good chance that core inflation y/y stays at 2.1%.

The next year will be very interesting for inflation. Adding QE3 when core inflation is already at 2% is gutsy, or foolhardy (depending). At some point, surely the water overtops the dam – no matter how much “willpower” is applied to stop it. It isn’t as if inflation hasn’t been rising already.

Also, tomorrow we’ll get Retail Sales (Consensus: +0.8%/+0.7% ex-autos). It seems incongruous to me, given the economic weakness of late, that economists are looking for a second straight strong print from core Retail Sales. Also out tomorrow are Industrial Production/Capacity Utilization and the University of Michigan Confidence survey, neither of which matter much.

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