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The Storm Before The Quiet

Yesterday’s flailings in the inflation markets were not repeated today. Breakevens and inflation swaps settled back a few basis points in a comparatively quiet retracement. Bonds rallied a couple of basis points (except for the very long end, which weakened) and stocks were roughly unchanged. With the Employment report due tomorrow, such quiescence isn’t abnormal, but coming a day after the TIPS market was shot out of a cannon the abrupt transition to peace from war was jarring.

The Fed speakers today sounded a dissonant note to the recent chorus of QE2-supportive commentary from other officials. It was no surprise that Kansas City Fed President Hoenig opposes further easing; he has been the hawkish dissenter for some time. At the last meeting, he dissented to the plan to roll proceeds from maturing/prepaying securities and buy more securities so that monetary policy would not become restrictive. Today, he said he is “horrified” at talk that the Fed might consider raising the inflation target in order to provoke lower real interest rates. Prepare to be horrified some more, sir! Hoenig went so far as to suggest that the Fed needs to promise it will move rates “off zero” in the future. Promising future tightening seems an odd approach, and completely at odds with the main body of the FOMC. We can safely assume that when it is Hoenig’s time to speak, the other members of the committee will take the opportunity for a restroom break or to replenish the ice in their glasses.

Dallas Fed President Fisher commands somewhat more respect, and his comments today serve to add a small dollop of risk to the possibility that QE2 will be announced in November. He claims that “markets have drawn too quick a conclusion,” and that easing further is “not a done deal.” I am not so sure about that, although I am sure that Fisher would like to think that his trip to Washington isn’t merely to rubber-stamp a decision that appears to have mostly been made by now.

Way back in August, when economic data was in the middle of a run of weakness, I suggested that the Fed would likely conduct the next leg of quantitative easing in November or December, and only if it became clear that Congress was not going to do much to avert the huge fiscal drag that will hit in the new year. The data, fortunately, leveled off from what appeared to be the beginnings of another dive, but that was never the strongest argument for QE. The strongest argument was, and is, related to the visible fiscal drag that is just ahead and the political reality that Congress is unlikely to be able or willing to counter that drag. If you oppose further QE, you must believe one of the following: (a) Congress will be able to avert the fiscal drag, (b) a huge jump in taxes will not affect growth, or (c) QE will not do anything for growth and the Fed can avoid being blamed for doing nothing. I don’t believe (a) or (b). While I think there is a good argument to be made for the first clause of (c), the reality is that if the Fed does nothing – whether or not they have a good reason for, um, not doing it – they will be drawing a bright red bull’s-eye on the building at the corner of 20th and Constitution.

Now, if the Democrats hold onto Congress, it is probably the worst thing that can happen to their party and the best outcome for the Fed. Then, the bright red bull’s-eye will be moved back to Congress. If the party which holds the Legislative and Executive branches extends the Bush tax rates, they’ll be assailed as blowing up the deficit; if they do nothing, they’ll be accused of not caring. In that case, the Fed would be well-advised to hold off on QE until and unless there are signs of deflation, of which there aren’t any right now. If the Republicans win, however, they can plausibly do nothing (or a half-measure) since, after all, they are winning on a platform of fiscal conservatism – whether or not you actually believe they will be fiscally conservative! Knowing the Republicans, they will then proceed to squander that advantage.

But all of that is next month.

The consensus for the last Employment report prior to the election and the FOMC is for a gain of 75k private jobs net of Census workers. Last month, +67k led to a big selloff in bonds, but despite weak signs from ADP economists are calling for an improvement, albeit a small one, in the labor market.

Such a gain in payrolls would not be sufficient to maintain the Unemployment Rate at its current level, so economists are expecting a rise to 9.7%. This isn’t a very big jump, actually; last month’s unrounded ‘Rate was 9.642% so the real surprise is if the ‘Rate stays at 9.6% with that level of jobs. It would not take much to print a 9.8%. (Such a number may actually be bullish for equities since many people would assume it cinches QE2. As regular readers know, I think QE2 is a silly reason to buy stocks, which typically do poorly when inflation accelerates, but conventional wisdom holds otherwise.)

Average Hourly Earnings isn’t usually a market-mover, but last month AHE surprised by rising 0.3% against expectations for 0.1%. The consensus for tomorrow is 0.2%, but another upside surprise would raise another objection to QE2 from people who believe that wage-led inflation is more just a scary story that economists tell their children. I am not one of those people, so I am all for higher wages, but if we get another 0.3% then brace yourself for the march of hawkish economists.

As I said before, I don’t think any of this economic data is likely to have an impact on the Fed’s decision next month unless there are some real outliers, but the market may not be so sanguine. Ironically, evidence of stronger growth may be a negative for equity and bond markets if in investors’ eyes it reduces the likelihood of the Fed pumping more liquidity into the economy. But I don’t think anyone is very sure, and I suspect we will have an hour of whippy trading and then liquidity will start to thin before the three-day weekend.


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