Scotiabank Asks The Most Important Question

Via Guy Haselmann of Scotiabank,

QE – Speculative Market Fuel

· A weak economic report lifted an overbought equity market to even-loftier historic highs. Investors and traders have become programmed to believe that QE (rather than economic growth) is enough to launch asset prices ever-higher. At the moment, there is little to refute this view. “Melt-up” mentality is back. However, shouldn’t a sluggish economy with slow job creation make investors question whether enough economic activity will be generated to justify prices? Unless the economy improves materially, then today’s move is just another example of speculative excesses caused by QE.

“Adequate Progress” – Undefined

· The key to market direction appears to be driven by assessing the timing of any changes to Fed action. The longer QE lasts the higher prices are expected to be pushed, thus the basis for today’s rally. However, reacting so robotically may not be so straightforward. After all, the FOMC communication has not been that helpful. This is because they say that asset purchases are “dependent on the state of the economy” and “making adequate progress”, yet they never define what “adequate” means.

Unemployment Rate Creeping Toward the 7% Threshold

· The FOMC initially presented “thresholds”, saying QE would end when the unemployment rate (UR) hit 7.0%, but the rate has already hit 7.2%. How will the markets react if the rate falls to 7.0% with the next employment report two weeks from Friday – and QE has not yet ended (let alone begun)? Would the Fed lose credibility if this occurs? Would it spook markets who are now expecting QE to continue well into 2014?

Fed Policy Based on an Unstable Indicator

· The Fed has problematically tied their policy to an inherently unstable and unpredictable economic indicator (i.e., the unemployment rate). This guidance may need to change as they develop a (sorely-needed) QE withdrawal strategy. Formulating and communicating such a strategy would be helpful to markets as well as to the FOMC who would benefit from getting all members on the same page.

FOMC Press Conferences

· A detailed or updated QE exit strategy could be presented at the October 30th FOMC meeting. The stakes are rising, so announcing that a press conference will occur at every meeting is likely.

· “I live on a one-way street that is also a dead end. I’m not sure how I got there.” –Steven Wright