Terrible deflation fears. Terrible yields on Treasuries. And now terrible non-farm payrolls for July — with more terrible yields. The market really expects the Fed to unveil another round of quantitative easing at its Tuesday meeting, in short.
But what if it doesn’t get it? Because, as analysts pointed out on Friday, the NFPs might not provide the turning point just yet.
Here’s Marc Ostwald of Monument Securities, for example:
On balance the report (subject to future revision) really does not tell us anything new, the broader Q2 trends will certainly give the Fed plenty to discuss at Tuesday’s FOMC meeting, but beyond ensuring that it decides to ensure that it will not, in effect, drain its outstanding volume of QE by reinvesting such receipts into Treasuries (because its Agency MBS and Agency Debt purchases have damaged liquidity), this is not a recipe for more QE. After all pumping money into a liquidity trap, which will do little to lower SME lending rates or Mortgage rates, looks to be rather futile to my perspective! Hence there is a risk that market expectations for “FOMC action” on Tuesday may be disappointed…..
Barclays Capital’s Dean Maki isn’t too impressed either:
While we expect the Committee to do contingency planning and discuss its options if growth were to fall persistently below potential, we think it is premature for it to implement such plans now. In June, the FOMC forecasted growth of 3.0% to 3.5% this year, and even stronger growth in 2011 and 2012…
If the Fed were to move to additional stimulus measures next week, it would be a clear signal that it had lost confidence in this forecast; we do not think that recent data have been so weak to warrant such an abrupt change in the Fed’s view. For example, the July employment report showed private sector job growth of 71k, broadly consistent with that in May and June, and private sector hours worked rose 0.3% on the month and are up at a 1.8% annualized pace so far in Q3 10. The unemployment rate held steady at 9.5%. If the data were turning toward contraction, hours worked would be shrinking and the unemployment rate rising.
While his BarCap colleague Michael Gapen reckons the moneyness of the deflation floor put option in Tips is pricing in a low-to-moderate risk of the Big Pfft. (The Treasury creates this floor through adjusting the final principal payment to make up the difference in original par amount and inflation-adjusted par, if the latter comes in lower.) As he notes:
The value of the embedded put option is dependent on the inflation-adjusted par amount, the dynamics of the inflation process, and the par value strike price. A higher inflation-adjusted principal amount, higher mean expected rate of inflation and lower inflation uncertainty all reduce the value of the deflation floor. Conversely, lower inflation-adjusted principal, lower expected inflation (or deflation), and higher inflation uncertainty all increase the value of the deflation floor.
Using a little bit of Black-Scholes pricing and some plug-in numbers (historical CPI volatility, expected CPI of between 1 and 1.5 per cent), Gapen gets the following probabilities for two Tips maturities:
Leaving us with deflation probabilities of around 10 to 15 per cent — according to Tips investors. Although we’ve noted recent, err, tipsiness in this market.
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We’re not saying the analysts are right, of course — not least, the Fed could simply be positioning itself in a holding pattern for easing policy later, if it doesn’t act now, and it’s simply waiting for more data.
What we are saying, though, is that hell hath no fury like a disappointed market.
Related links:
A sputtering economy? – Econobrowser
Faltering US recovery trips dollar – FT