Markets Hang in the Balance Awaiting the Fed

As I wrote in last week’s column, this will be a September to remember. Now the $64,000 question is: Will they or won’t they?

Anticipation is running high that the Federal Reserve will unveil yet another round of quantitative easing (QE) today. We should know the outcome one way or another by 2:15 this afternoon, when the FOMC concludes its two-day policy meeting.

Expectations have increased dramatically in recent weeks as economic data turned soft, and Fed Chairman Ben Bernanke revealed the Fed is disappointed with the U.S. economy’s lackluster performance.

In fact, a Bloomberg news story early this week put the probabilities of QE3 at 99 percent — or a virtual done-deal — we shall see.

Given the avalanche of media coverage and “leaks” anticipating QE, markets are likely to be sorely disappointed if the Fed stands pat this afternoon.

But the truth is, we may be in store for a sell-the-news moment even if Bernanke & Company delivers on what the markets expect.

Key Factors in the QE Debate

Let’s face it, the Fed’s policy actions have always had more of a psychological effect on markets rather than providing any tangible benefit to the real economy.

Stocks and commodities have gotten a lift after previous Fed easing. But it’s been a case of diminishing returns with each new round of QE resulting in less of a boost for markets.

So what data is the Fed most closely deliberating right now behind closed doors in Washington?

Let’s take a look at a few charts that the Fed is no doubt pondering …

The focus for the Fed used to be squarely on inflation — more specifically on the market’s expectation of future inflation rates. But since the 2008 financial crisis the key issue has really been a lack of inflation.

The chart below shows the inflation-indexed 10-year U.S. Treasury yield spread — it’s the difference between the standard 10-year Treasury note yield and the 10-year inflation-indexed (or TIPS) yield — and it’s closely watched as a gauge of expected inflation a decade out.

Click the chart for a larger view.

As you can see, each time the Fed launched QE in the past, inflation expectations were already low and sinking — below 1 percent in 2008 and early 2009 when the Fed launched QE1 — and under 2 percent when QE2 and Operation Twist began.

But this time around, inflation expectations have been rising, to 2.38 percent today, up from just 2 percent early this year. In other words, inflation expectations appear to be rising on their own … with no need for more QE to do this job.

While inflation expectations remain a key factor in the Fed’s debate, it’s certainly not the only indicator they’re deliberating today. If it were, then the case for QE3 would not be a very strong one.

But there’s another indicator the Fed is giving greater weight to these days.

The Fed’s Favorite New Indicator

Minutes from the last Fed meeting showed “many” FOMC members are leaning in favor of more policy action, since the economy continues to struggle with high unemployment.

And just a few weeks ago, Bernanke himself made clear in his Jackson Hole speech that the U.S. economy “remains far from satisfactory” … specifically saying high levels of unemployment were a “grave concern.” It’s easy to see why …

Click the chart for a larger view.

Job growth — or lack of it — is now THE hot-button indicator for the Fed, as shown above, and in the charts below. And there’s good reason to be concerned:

• The headline unemployment rate declined slightly to 8.1 percent in August, but has been stalled above 8 percent for 43 straight months!
• Meanwhile, the broader U-6 unemployment rate, including part-time workers who can’t find full time jobs, stood at 14.7 percent in August.
• Monthly new job creation has averaged 139,000 this year, not nearly enough to help the 5 million long-term unemployed who have been without a job for an average of 39 weeks.

Click the chart for a larger view.

When you look at the chart above, it’s easy to understand why the Fed is unsatisfied with the slow pace of job growth during this recovery.

That’s why last Friday’s putrid payroll report was probably enough to tip the balance in favor of Fed policy action, whether it comes later today, or at some point later this year, perhaps after the election.

On that note, recall that QE1 was announced 11/25/2008; and QE2 purchases began on 11/3/2010. In both cases elections took place the same month. Or, perhaps there’s some other reason why the Fed prefers major policy action in November?

Ironically, Bernanke and “many” of his Federal Reserve colleagues firmly believe that unemployment is a cyclical problem that more money-printing can somehow cure. But as the chart above illustrates, today’s high unemployment — several years into an economic expansion — is not the norm and appears to be more of a structural problem within the U.S. economy. It’s a problem that will take much more than easy money to solve.

Good investing,

Mike Burnick

Mike Burnick, with 30 years of professional investment experience, is the Executive Director for The Edelson Institute, where he is the editor of Real Wealth Report, Gold Mining Millionaire, and E-Wave Trader. Mike has been a Registered Investment Adviser and portfolio manager responsible for the day-to-day operations of a mutual fund. He also served as Director of Research for Weiss Capital Management, where he assisted with trading and asset-allocation responsibilities for a $5 million ETF portfolio.