“The commodity price boom is over and anyone with half a brain knows that.” so said Martin Ferguson, Australia’s Resources minister this morning.
After the release of the last FOMC meeting minutes showed that the FOMC closely discussed all its options for providing more monetary stimulus. Most members, although not all, stated that they believed that the US economy is still not strong enough to stand on its own and have a sustainable recovery. There are just too many headwinds.
Given that whilst the market may have looked at the US economic data released in the last 3 weeks as showing some improvement, it has not been at such a level that the FOMC members arguing for more QE would change their view at the September 12th-13th meeting. So the market has had a huge about face and now expects a huge stimulus programme to be launched at that meeting and expects Bernanke to allude to that at his August 31st speech at Jackson Hole.
But the markets will be disappointed again. Firstly Bernanke has no mandate to announce any QE at Jackson Hole as he will not have had a vote from the FOMC – what he may however state is what he said back in 2002 when he outlined what the Japanese did right and wrong in their lost decade. Secondly, there are plenty of doubters within the FOMC as to the efficacy of any QE and as such this time round it is very likely that any asset purchases announced will be significantly less than previously and probably will be reviewed at the December FOMC meeting. Those FOMC members opposing more QE will look at the inflation expectations to justify their opposition, so I see it as 50:50 as to whether we get QE3 and even if we do it will be a watered down version.
That hasn’t stopped the commodities and US equity markets from rallying though as the US$ weakened against all the major currencies.
But the reason behind the need for further QE is exactly why commodity prices should be falling- that is that Global growth is stalling and as the Australian minister put it so succinctly, “…anyone with half a brain knows it” . So this rally is the same as we always see when QE is rumoured. It is a classic buy the rumour and sell the fact scenario. Everyone will rush for the exit if any QE is announced or as is even more likely disappointed at the level of any QE. So I do not expect any commodity rally to last.
Yet again though the FOMC minutes have done the reverse of what the Fed wants. Implied Interest Rate Volatility has risen since the minutes were released and is set to rise significantly further. One paragraph inside the minutes points to the fact that the FOMC is not expecting to tighten monetary policy and change its 0-0.25% funds target until well after any economic recovery has started and as such is really saying that the low interest rate policy is here to stay, probably for the next 3 to 4yrs at least. As such it makes the front-end of the US Treasury curve cheap. 5yr Treasury yields have fallen 11bp in the last 2 days to stand at 0.68%, but if rates are staying at close to zero even until the end of 2015, then they have at least another 18bp to fall and 5yr Treasury yields will fall below 0.50% . Whilst that occurs we will see a sharp rise in implied volatility in that area of the interest rate curve. And that rise in the price of hedging interest rate risk will have to impact other markets.
It all points to further declines in US Treasury yields across the curve. After the moves last week have mostly been reversed, the shorts in the Treasury market will now need to be covered. I would expect the news flow from Europe to continue to be negative and as such 10yr US Treasury yields should end the month at or around where we started. 1.50%.