Will the Fed Sabotage QE III for the Fiscal Cliff?

Is the Federal Reserve trying to sabotage QE III for the sake of the fiscal cliff? There are quite a few signs, which we’ll talk about in just a few moments. Besides, when it comes to our officials, whether appointed or elected, nothing is out of the realm of possibility.

While we can’t predict exactly how Congress will agree to address the fiscal cliff, we can probably look forward to a “Congressional Can-Can.” That is, I’m inclined to think lawmakers will do what they do best — kick the can. And they’ll do so as forcefully as possible to send the problem far into the future.

Adding to the intrigue is the renewed gridlock in Washington, D.C. Congress remains divided and President Obama has been re-elected. Anyone — House Republicans, Senate Democrats or the president himself — can throw a wrench into the negotiations at any time.

So now, the biggest question becomes less about how the cliff will be addressed, or when it will be fully addressed, and more about …

Who Has the Most Leverage?

One might think, considering the brash nature of President Obama and his administration, Democrats would use their current momentum to force Republicans to come their way.

But Republicans, bitter after the election results, may be determined and actually better-positioned to coax Democrats their way.

The “R’s” may have more leverage than meets the eye. Here’s why …

With a second term secured, the president now looks to his legacy. If he is concerned about his after-office appeal, he’ll be very cautious not to completely alienate the country by risking a disastrous economic event, should no agreement be reached.

He’s playing “prevent defense” at this point. But his offensive coordinator may have some tricks up his sleeve …

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Enter Federal Reserve Chairman Ben Bernanke

He’s on record with new comments urging lawmakers to reach an agreement.

“The realization of all of the automatic tax increases and spending cuts that make up the fiscal cliff, absent offsetting changes, would pose a substantial threat to the recovery.

“Indeed, by the reckoning of the Congressional Budget Office and that of many outside observers, a fiscal shock of that size would send the economy toppling back into recession.”

But that’s not a fresh idea — he’s made news with similar comments throughout the year. Additionally, several other Federal Reserve members have come out saying the Federal Reserve can’t do much more to support the economy and that Congress must become proactive.

Mr. Bernanke must know that almost half the country doesn’t want to swallow more public sector “support.” He must know that the nuances of monetary policy can fly under the radar far more easily than those of fiscal policy.

Now we’re hearing more calls for Fed transparency, which has been a recurring theme in the last few years. Bernanke’s now-regular post-Federal Open Market Committee press conferences are among the efforts taken to disclose the workings of the central bank.

Ron Paul has garnered a whole lot of momentum with his book “End the Fed” and his “Audit the Fed” transparency bill that passed the House back in June a decade after he introduced it.

The Federal Reserve acknowledges the issue of transparency. But that begs the question …

Are We Really Ready for Transparency?

Recent calls for transparency have been quite specific — to set quantitative conditions on the latest quantitative-easing operation. That is: Tell us what nominal gauge will bring an end to QE III.

More importantly, guess who is making these calls for more transparency? Federal Reserve members!

Remember: QE III is open-ended. The Fed will keep buying mortgage-backed securities (MBS) and twisting the duration of bond purchases each month until they see sufficient economic momentum. They may even initiate a new bond-buying program.

Now, the definition of “sufficient economic momentum” was also left open-ended. The Fed purposefully chose to use a qualitative gauge for recovery. And here’s why …

Since the announcement of QE III in September, I’ve been warning of the potential for the market to front-run the Fed and anticipate the end date for QE III. And that would likely mean a sell-off in the markets that erases much of the QE-led uptrend.

The trigger could be a notable improvement in unemployment … or consecutive trend-level growth in quarterly GDP … or a stretch of improved manufacturing and consumption data … or something else.

Naturally, then, the Fed wouldn’t want to hasten market expectations because it would undermine the potential effectiveness of its latest policy actions, right?

The Fed’s Altruism at its Finest

Oddly, the Fed seems to be consciously undermining the effectiveness of QE III.

Fed members, save Bernanke, are talking about outlining a concrete unemployment level, or inflation rates, or a calendar date at which point they’d consider abandoning their current easing efforts.

To reassure the QE faithful, members insist such quantitative thresholds would not be absolute. But that may not matter to market players trying to predict Fed behavior.

Most agree QE I and QE II did little, if anything, to improve the real economy. The Fed relied on the wealth effect of rising stock markets to support the habits of consumers and businesses.

They realized that, even after injecting the financial system with the equivalent of half the world’s current GDP, the best they could do was avert a depression.

But here we are now and some analysts are predicting QE III could actually work for the real economy by shoring up sentiment of businesses and consumers and inciting activity. Actually, I wrote about this idea recently: Read it here. (Be sure to read, and participate in, the discussion in the comments section.)

It certainly might help. The difference between QE III and previous periods of monetary accommodation is its open-endedness. Why would the Fed risk undermining their own support measures?

It’s been said only a major market meltdown will bring about needed action on the fiscal front. After all, that’s what happened in 2008 to necessitate stimulus measures. Might the Federal Reserve “inadvertently” create the conditions for a market meltdown as they flirt with increased transparency?

It may be a roundabout way to pressure lawmakers into folding, taking up the status quo and delaying the inevitable yet again.

Barring any real action from the Fed on transparency, I believe the market will take the fiscal cliff deadline in stride. The downside correction in risk appetite appears to have run its course. Markets can run higher.

‘Tis the Season for Bigger (Risk) Appetites

The Chicago Board Options Exchange’s Volatility Index (VIX) has come to reflect the sentiment of traders. Periods of high and rising volatility have corresponded with periods of risk aversion; and vice-versa with periods of risk appetite.

I received a piece of technical analysis on the VIX a couple weeks ago. It highlights an indicator that might help predict market direction at key VIX inflection points. The indicator is a basic cross in two moving averages identified as being important.

I’ve been watching this chart (I recreated it for you below), and I see a set-up similar to earlier this year. At that time, risk appetite recovered and sent markets rallying.

Might we see a repeat?

The S&P 500 rallied about 16% back when this VIX indicator gave us a head-fake in June … nearly identical to what it’s doing right now.

This adds validation to my current bias expecting a rally through year-end. It may make sense to add U.S. stock and index ETF exposure to play for a year-end rally.

The Big Risk: Fed Sabotage

I couldn’t help but consult the wisdom of the Beastie Boys to [w]rap this up:

“So, so, so, so listen up ‘cause you can’t say nothing

‘You’ll shut me down with a push of your button?

But you, I’m out and I’m gone

I’ll tell you now, I keep it on and on

‘Cause what you see you might not get

And we can bet, so don’t you get souped yet

You’re scheming on a thing that’s a mirage

I’m trying to tell you now, it’s sabotage.”

If the Fed chooses to sabotage its latest efforts to indirectly pressure lawmakers on the fiscal cliff, it will drag markets lower. Again, watch the VIX …

Any market decline could extend if the moving averages cross in the chart above, suggesting greater volatility and investor unease to come. I’ll keep you up to speed on that.

Best,

JR

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“JR” specializes in trading commodities, currencies and options. He has spent nearly 10 years analyzing financial markets and writing about global economics. JR honed his trading techniques and global-macro worldview alongside his father, Jack Crooks, at Black Swan Capital. JR also …