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The Stocking Is Mostly Full

With the exception of a resolution to the budget crisis, Tuesday probably saw the best combination of possible news and expectations that we could have for the remainder of 2012. The stocking is mostly filled with all of the gifts we are likely to get this year.

It started with the announcement that Greece managed to meet its goal for the bond buyback, as it attracted some €31bln in tenders. As it turns out, they had to pay more than the absolute highest price they were supposed to pay (the closing price on November 23rd), but as I noted at the time there was little to no chance of Greece completing the buyback without paying above-market prices, unless the sellers were coerced in some way, so that wasn’t really news.

Now, according to the Bloomberg story, the Euro finance ministers get to meet on December 13th to decide whether to release the €34.4bln tranche of the rescue which was contingent on a successful buyback. But the deal is almost done. Given the interest holidays and the lengthened maturity of Greece’s debt, it is looking increasingly likely that they’ve managed to delay the day of reckoning substantially. Sure, they did that by moving all of the debt to official institutions, who will carry it at par although it will eventually be defaulted on. Sure, this creates the risk of me-too-ism from other PIIGS who would like a lengthy payment holiday and hundreds of billions of Euros in support. But the risk that Greece will need to default in the near-term is passing. Of course, so is the need for Greece to continue austerity, once they’ve gotten everything they need from the Eurozone finance ministers. Maybe they were more clever than I gave them credit for…

So Greece was good news, and we’re also cheerfully waiting for tomorrow’s FOMC meeting. The results are so widely expected as to lead one to expect the intentions of the Fed had been carefully vetted beforehand. The overwhelming consensus is that the Fed will announce that they will cease half of Operation Twist: the half that has them selling short-dated Treasuries, of which the Fed now has almost none. The consequence is that the Fed will now be outright buying about $45bln in long-dated Treasuries, over and above what they were already purchasing in QE3, per month, without end.

Obviously, equities liked this idea because we all know that the script says stocks are supposed to ramp up into QE. More surprisingly, long-dated Treasuries actually slipped a bit lower. The 10-year yield is at 1.65% and 10-year real yields at -0.89%.

Now, here’s the problem as we roll into Wednesday. There’s really no chance that the Fed is going to do more than $45bln per month in Treasuries purchases, especially with the inconvenient (albeit cosmetic) downtick in the Unemployment Rate this month. Therefore, what is priced into the stock market is pretty much the best-case for QE.

Is there any chance that the Fed might actually do less, or even defer until the next meeting the decision about whether to pursue an acceleration of QE? The chart below (Source: Bloomberg) shows the 5-year inflation breakeven, 5-years forward, taken from TIPS and Treasuries.


Clearly, while inflation expectations are “contained” in the Fed’s view, they are plainly becoming steadily less-contained. The 5y, 5y forward BEI has been rising in a trend for fourteen months now, and it is above 3%. In inflation swaps, which don’t have embedded the financing advantage of nominal Treasuries over TIPS, the 5y, 5y forward is 3.17%. In short, the market is currently pricing expectations that the Fed will fail in its mission to keep core CPI inflation around 2.25%, and that there will be a long-lasting deviation from that target.

(As an aside: we can’t tell just from the point estimate taken off the yield curve whether market expectations are for a steady miss, or whether the expectation is for something fairly close to target, but with considerably “option value” because the upward tails are a lot longer than the downward tails. It appears that both are currently contributing to the high forward breakevens because implied inflation volatilities have been rising.)

Now, like everyone else I expect that the Fed will stay on the course that has been laid out for them by the market, and endorse a QE4 plan tomorrow. And I don’t think we’ll get Evans Rule parameters tomorrow. But, as I said, all likely surprises from that expectation are negative for equity markets, and even if the Fed delivers what has been writ then I’m not sure where we get a further rally unless the fiscal cliff is averted.

  1. hallmachine
    December 12, 2012 at 10:13 am

    Hi Mike, have you seen the index FED5YEAR ? If so, do you know the difference between it and your graph above?

    • December 12, 2012 at 10:25 am

      Yes, that’s calculated by the Fed using a model that attempts to correct for some quantitative factors (like seasonality, embedded floors, etc if I remember correctly, including some like “liquidity preference premium” that they basically made up so that their model worked). Basically pointy-head economists trying to come up with a number that’s better than the market price. I read their original paper on the topic and recall thinking “it’s a good idea to try and take these influences out of the forward, but why not just use CPI swaps then?” CPI swaps, which are plenty liquid, don’t have the problems of embedded floors or financing differentials, and it’s the right way to look at inflation expectations most of the time (although around the crisis the forwards got really wacky so that’s why I don’t show the time series in the swaps). And that’s 3.17% as I noted.

      So I’m not entirely sure I recall what the FED5YEAR indicator does, except that it’s hard to understand. 🙂 Thanks for pointing it out though!

    • December 12, 2012 at 10:29 am

      Here’s what Bloomberg says about the index, for what it’s worth…note the last line:

      Fed’s Five-year Forward Breakeven Inflation Rate
      This data comes from a Federal Reserve working paper and will be update periodically. The TIPS Yield
      Curve and Inflation Compensation by Refet S. Gurkaynak, Brian Sack, and Jonathan H. Wright. 2008-05
      Abstract: For over ten years, the U.S. Treasury has issued index-linked debt. Federal Reserve Board
      staff have fitted a yield curve to these indexed securities at the daily frequency from the start of 1999
      to the present. This paper describes the methodology that is used and makes the estimates public.
      Comparison with the corresponding nominal yield curve allows measures of inflation compensation (or
      breakeven inflation rates) to be computed. We discuss the interpretation of inflation compensation and
      its relationship to inflation expectations and uncertainty, offering some empirical evidence that these
      measures are affected by an inflation risk premium that varies considerably at high frequency. In
      addition, we also find evidence that inflation compensation was held down in the early years of the
      sample by a premium associated with the illiquidity of TIPS at the time. We hope that the TIPS yield
      curve and inflation compensation data, which are posted here and will be updated periodically, will
      provide a useful tool to applied economists.

    • December 12, 2012 at 11:17 am

      If you use 7/17s and 7/22s in TIPS, you get something fairly close to the Fed series. I’m willing to believe that Bloomberg might be messing up their own index (maybe following a very old 5y and 10y TIPS, e.g.), but in any event we’re up near 3.20% in swaps and the same trend is evident. Thanks for pointing it out, though. Sometimes when I’m writing these quickly, I grab the easy data rather than the BEST data.

  1. December 12, 2012 at 2:52 pm

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