Breakevens to the Fed: "Your move"

Today is perhaps the most interesting day in Rates markets I can remember since the Fed first formally announced that it would begin Quantitative Monetary Easing in March. It is interesting because 5y5y TIPS Breakeven Inflation looks about to close at a new high around 2.9%. This is important because it is outside the accepted range considered to be "well-anchored" and would be the first time that they have closed outside of this range.

We have been here before on several occasions over the past couple of years. The market has often interpreted the Fed (and policymakers in general - excluding the ECB) as always "going for growth. Many will recall the rants of Jim Rogers et al crying that the Fed was printing money and trashing the Dollar and that Gold was the only sane investment for those wanting to preserve their purchasing power. The recent break of Gold above 1100, cheered on by several notable hedge fund managers, and supported by several Emerging Market central banks, is adding to this perception. Will the Fed tolerate this given the criteria laid down during last week's FOMC meeting.

There are a few examples that I want to discuss, along with the Fed's responses to these moves. Firstly, in mid-January 2008, as equity markets were melting down as rogue trader Jerome Kerviel's portfolio was liquidated, TIPS breakevens widened significantly in response to the Fed's intrameeting cut of 75bps - an unprecedented move up to that point. The curve very quickly moved to price in a high probability of a 100bp cut at the end of January. However, the Fed - perhaps in response to this widening, as well as moves in the USD and Gold - disappointed markets. Breakevens duly tightened again back into the range.

Secondly, as Bear Stearns was undergoing its final liquidity squeeze in mid-March 2008, breakevens again widened to an intraday high of 2.94% on 14th March as the market began to price in the possibility of a 125bp rate cut from the Fed. With a rescue orchestrated for BSC, the FOMC once again disappointed, and breakevens returned to their range.

The next example comes in the week following the G7 meeting of late-April 2008 in which currency market volatility was discussed, but the statement did contain anything more than a vague promise to cooperate on exchange rates and the usual boilerplate around FX volatility. The FX market viewed this as a "carry on as before" message and duly took the USD to new lows. During this period, TIPS once again widened above 2.8% intraday. Shortly after, Fed rhetoric on inflation was stepped up and the front-ends of curves collapsed as rate cuts were priced out (cumulating in Trichet's summer "present"), TIPS returned to their range.

The final example is 15th September 2008, the date that Lehman Brothers filed for Chapter 11. Many financial market participants initially viewed the event as an extreme Dollar-negative (myself included) as a classic EM-style run on the capital account - by virtue of refusing to fund the banking system - would require a full fiscal bailout of the financial system and associated debt monetisation. 5y5y TIPS breakevens traded to an intraday high of 2.935% that day before collapsing in October & November under the weight of dealer deleveraging and a view that a deflationary outcome was inevitable. But an event that far fewer remember is that at the FOMC meeting that week, despite the curve pricing in rate cuts in response to the Lehman failure and other associated fall-out, that the Fed kept rates unchanged.

It is clearly evident from their prior behaviour that the Fed is uncomfortable with inflation expectations straying too far from their implicit target. It appears to me that a chain of events has been set in place whereby the Fed (and policymakers generally) have told financial markets that they will not be enacting exit strategies for a significant period of time. The size of the output gap is cited as the reason that inflation will stay low - and is one with which many participants (including myself) agree with. But something is wrong. If this is the commonly held view, then why are breakevens soaring to new highs that indicate that the market expects higher inflation? A dangerous game is being played whereby the market is calling the Fed's bluff - will the Fed step up to the table? The market knows that the Fed knows that it cannot afford even to let expectations stray a little - because as soon as they stray a little and nothing is done, they will stray a little more, and so on. Central banks have cashed in a lot of the capital they have built as inflation-fighters over the past 30yrs, and it is remarkable that it has taken until now for it to be seriously tested.

The liquidity-driven rally in everything that is not the USD has been given an implicit "OK" by policymakers. Will they be "OK" with the side-effects?

My sense is that we are on a collision course with a policy response.