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With the announcement of a third wave of asset purchases by the Feds, there are some indicators that give us reason to develop a positive view of things to come.

Some critics argue that the Feds actions are going to stoke inflation. While this argument has partial merit, the Feds are in essence trying to raise inflation expectations to avoid a deflationary spiral by encouraging consumers to spend now instead of waiting for prices to fall in the future.

An indication of these expectations as can be seen by the 5 year 5 year forward break even rate (based on nominal 5 yr bond forward rates minus inflation linked bond forward rates) which gives us an indication of inflation expectations beginning in 2017 (5yrs) to 2022 (5yr forward).

This gauge is sitting at a 1 year high of 3.03 up 6% since the Bernanke announcement.

We can also see this from the steepening of the yield curve as investors pull back from longer duration treasuries and yields increase at the long end of the curve.

Inflation can be qualified given the current economic scenario.

Good inflation is consumer-demand driven that results in the flow of money in the system, boosting profits, encouraging corporate expansion, increasing hiring, higher asset prices and ultimately creating the virtuous cycle of economic growth.

Bad inflation is the kind that has an immediate negative impact on the consumers disposable income. Typically this is supply driven inflation and the biggest contributor to this phenomena is higher oil prices. Until a certain price point, higher oil prices are seen as a strength of economic activity i.e they move in tandem with the equity markets. However, oil above a 100$ starts impacting the average consumer and the correlation no longer holds true. Typically, if there is no supply disruption, the price is bid up by speculators and the positions are reversed when the spread widens too much as you can see below.


Of course, there is a very real risk that supply-induced inflation outpaces demand driven consumer spending as the latest numbers by the labor department show a 0.6 percent rise in consumer prices due to spending more at gas stations, with no change in real wages.

However I believe that market forces will keep oil prices in check in the long run as they have been over the past 5 years.

What else is good?

Aside from inflation expectations, the other major positive indicator is increased investor risk appetite.

One of the fundamental goals of the QE program is to depress yields in conjunction with a zero interest rate policy to encourage investors to park their funds in higher yielding assets.

Corporate debt spreads are at their narrowest in years and the Junk bond market represented by SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK) is yielding below 7% which is a level not seen since the 80's.

Yield crazed investors are going to great lengths to get that extra boost and are even investing in extremely risky things like catastrophe bonds.

The flurry of debt issuance by companies that are trying to take advantage of the low interest rate environment, combined with massive investor demand for new avenues to increase return is all a very positive sign that will help to improve economic fundamentals.

Are there hurdles to economic recovery?

Most definitely.

We have political uncertainties in the United States with the presidential elections and the fiscal cliff approaching, which will again test the resolve of the government to do what is best for the economy.

Then there is Europe which has been given a temporary reprieve from the bond market; but has to utilize this time to get its fiscal house in order and work toward creating a more unified framework that instills permanent confidence.

On the bright side, China and quite possibly Japan are likely to announce a renewed stimulus package which should give the global economy a shot in the arm which will in turn have a positive impact on the United States.

Gradually, the trend of negative economic data should reverse as global players improve their position and inflation expectations along with renewed investor risk will begin to create a demand driven recovery.

Hopefully, the third time's a charm.

Source: QE3: The Third Time's A Charm