We’ve already posted about how investors are front-running the Fed, which is to be expected, but have they gotten ahead of themselves as well?
In agreement with those queasy Barcap analysts, economist James Hamilton thinks the market is already pricing in a huge amount of extra asset purchases (emphasis ours):
It’s certainly striking how much yields have declined as the conviction of a second round of quantitative easing (referred to by some as “QE2″) has grown. Over the last month, the 10-year yield has fallen 40 basis points. If you wanted to attribute all of this to expectations of QE2, and if you were assuming that $400 billion in long-term bond purchases could lower the rate about 13 basis points, you might think the market has already discounted some $1.2 trillion in additional large-scale asset purchases. All of which raises the interesting possibility that if the Fed were to announce in November another trillion in purchases, nothing would happen, because the market has already discounted it.
The estimate of 13 basis points comes from his recent work with economist Cynthia Wu, though other estimates mentioned at the link point to a bigger effect, meaning that less if priced in. This survey from CNBC of 70 economists, fund managers, and traders puts the average expected amount of asset purchases at closer to $500bn.
Of course, the string of bad news in the last month, especially last week’s jobs numbers, would itself lead to lower yields regardless of the Fed’s intentions, and there’s really no way to separate just how much is from pricing in more QE.
All the same, Hamilton spots another conundrum (emphasis ours again):
But it’s curious that we’ve also seen commodity prices taking off at the same time interest rates are coming down. While a weakening economy makes sense as an explanation for falling bond yields, it does not make sense as an explanation for rising commodity prices. But a growing market conviction that QE2 is coming could be consistent with both.
Even so, I have a hard time fully reconciling the recent behavior of bond and commodity markets. It’s true that while the 10-year yield is down 40 basis points since September 10, 10-year TIPS are down 50 basis points, consistent with the view that there may have been a modest decrease in real rates and increase in inflationary expectations. That of course is exactly what QE2 is supposed to accomplish. But I’m doubtful that such a modest effect could be reconciled with the 10% moves in commodity prices we’ve seen over the same period. The people who think that 10-year nominal bonds paying 2.4% are a good buy, and who think that copper at $3.80 a pound is a good inflation hedge, can’t both be right.
Of course, commodity prices are influenced by factors other from QE2 expectations. As Free Exchange points out, demand for commodities (oil in particular) has been depressed the last couple of years by the global slump. But analysts are predicting that it will rebound driven by the needs of developing countries. Not that a weak dollar wouldn’t also contribute.
Meanwhile, click to enlarge this chart from finviz for a view of what’s been happening lately in the futures markets for these categories:
Looking beyond November, it’s interesting to think about what the Fed’s reaction would be if (and we stress the highly speculative nature of this if) headline inflation, driven by rising commodity and food prices, were to start running uncomfortably away from the core number — even as unemployment remains high and growth sluggish.
Given the signals it has given for the size of QE2, the Fed seems to be saying it’s a risk worth taking to get growth moving upward again. Regardless, we’re not there yet.
Related links:
The market moves ahead of the Fed – Econbrowser
QE2: estimates of potential effects – Econbrowser
A QE-easy trillion – FT Alphaville
Front-running the Fed – FT Alphaville