CPI, QE and Greenspan Put

The bond yields in the US for the 10-year paper remain unmoved yesterday. The 10 year is trading at 1.37, 30 year is at 2%. Dollar index is also mostly unchanged at 92.2. The US CPI data is due today where the expectation is around the increase of 4.9% for the June month on YOY basis. India also saw the release of inflation data yesterday where the reading came out benign (6.3% YOY) compared to market expectations (6.6%). The core inflation eased compared to last month. Anyways RBI’s mandate is to target the headline CPI number unlike the Fed where the Core PCE is targeted.

Now the market will start waiting for Powell’s testimony to the congress. Any deviation from the expected script which is caution on the virus, transitory inflation, and the employment market still to recover will be latched on by the markets. So far, the market participants are getting primed up for some kind of tapering discussion in the August meeting. The recent fall in the yields however shows that the link between the taper and eventual rate hikes is also getting weaker. The taper can happen now i.e. at least some reduction in purchases to start with and then a roadmap on how over a period of time the complete purchase will be stopped but the rate hikes are still way into the future.

One should remember the times during GFC when the first QE was announced it was with a defined amount which was 600 bn USD. Even in the QE2 the amount was 600 bn USD, it was only in QE3 which was an open ended 40 bn USD per month purchase which was then increased to 85 bn USD per month. The taper tantrum happened when the then Fed Chief Ben Bernanke in June 2013 announced that the Fed could decrease the purchase from 85 bn USD to 65 bn USD. This started a frenzy of Dollar buying across the world where the local EM assets were sold and the rush to invest in Dollar assets happened. The readers should note that hence any kind of an open-ended QE program introduces this problem, the market expects the bond buying to continue ad infinitum. Even if the purpose is no longer getting served it should continue just from the signalling perspective. In contrast to Fed, the PEPP program of ECB comes with an umbrella outer limit.

It should be noted that any bond purchase by the CB is done to provide liquidity to the commercial banks so that they can continue with the lending in the system. But the recent phenomenon of over reliance on the overnight repo facility of Fed by the commercial banks has shown that the lending opportunities are limited hence they are ok to get 0.5% on the IOER window. Any further QE will just add to this. Hence our expectation is that Fed will slowly try to wean off the markets of this monthly dose of liquidity creation. The approach would be different from 2013 and hence the markets will get time to adjust. Even the other nations are better prepared. Indian central bank has amassed a 610 bn USD war chest to ward off any run if it happens.

Wrapping up the argument today, all these central bank actions on QE generation and then in its response the reserve generation has given the markets a sense that periods of high and sudden volatility are less probable now. Readers would recognize that any such belief inserts a moral hazard in the system, this belief in fact allows or exhorts the participants to carry more risk, sell more volatility. Logic is that in case the volatility is going to remain low, why not make money in the meantime by selling the same. This in turn increases the overall risk in the system. We all remember the famous “Greenspan Put” during the 90s and early 2000s. More on it later.