Notes From Underground: Has the Fed Potentially Created a Trap For Itself??? (Maybe)

As the talk turns to concern about inflation in the U.S. and possibly the U.K., we must ask ourselves a question that will be our focus for at least the next six months.

Last week I wrote about the “Tail That Wags The Dog” (and I will repost the reference to the Robin Harding FT piece).

I reintroduce the Harding piece, titled, “The Fed’s Riposte on Short v. Long-Term Unemployment” because it is important to note the incipient battle over the idea of structural unemployment from the work of Professor Alan Kruger. Using the Kruger research, the Harding article conjectures that the “… long-term unemployed are to disconnected from the labor market to hold down wage inflation.” It boils down to maybe the OUTPUT GAP GENERATED BY HIGH UNEMPLOYMENT does not pose a deflationary threat as many models have supposed. It is an argument that maintains that it is short-term unemployment that is the reservoir of worker slack and the loss of skills from the long-term unemployed keeps them from being employed.

The argument is that the long-term unemployed will not act to keep pressure on wages and the Fed’s beloved “output gap” is not as dynamic as its models have suggested. Again, if the argument has merit, Chair Yellen will have to weigh how to affect interest rates with a large overhang of the Lumpenproletariat. If the unemployed are so skills challenged that they are unemployable how is the Fed to act without furthering hampering their ability to find a job?

IF PRICES ARE ON THE RISE AND UNEMPLOYMENT IS STILL DEEMED BY YELLEN TO BE CYCLICAL WILL SHE MOVE TO RAISE RATES EVEN IF INFLATION FAILS TO PUT UPWARD PRESSURE ON WAGES?

This is the ultimate question for global financial markets. If the Yellen Fed will tolerate price rises without stagnant wages then the stock market is correct and rising because investors know that Yellen will err on the side of workers at the expense of the bond and other financial markets. It is too early to get any real sense of this but a few trades will have to be monitored if my conjecture about Janet Yellen holds.

1. The 2/10 yield curve will begin to steepen as the market fears the impact of a FED that remains far too easy for too long;

2. GOLD and SILVER will rise as an alternative to fiat money as the market fears the repercussions from the Fed’s policy and the contagion it will spread to other central banks. The GOLD/EURO, GOLD /SWISS, GOLD/YEN and GOLD/YUAN will become very important barometers. Currently all the aforementioned trades are within sight of their 200-day moving averages. GOLD/EUR and GOLD/SWISS are below and the two Asian spreads are trading above their 200-DMA. This provides a mixed reading but will be important to watch.

3. The SPOO/BOND spread will break out to new highs as the risk to bonds will be deemed greater than stocks in the medium term. If rising wages become a drag on future profits then the SPOOS will stop being a haven trade for many investors. This is just a taste of what the market is beginning to digest and I haven’t even discussed the impact of the Bank of Japan and the European Central Bank responses to the Fed’s dilemma. This is merely a quick note to generate some thoughts on the key issue for global financial markets.

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5 Responses to “Notes From Underground: Has the Fed Potentially Created a Trap For Itself??? (Maybe)”

  1. arthur Says:

    Let’s party… Animal Spirits Chase BlackRock Into European Bond Refuge via Bloomberg http://www.bloomberg.com/news/2014-05-13/blackrock-joins-pimco-hiding-from-animal-spirits-credit-markets.html

  2. Chicken Says:

    “Fortunately”, we haven’t seen meaningful wage inflation for decades, thanks to numerous headwinds. PMs and just about everything else under the sun have risen despite this though, must be an indicator of global growth?

    When do the cash buyers run out of cash, about the time the GSE’s are back in business?

  3. Dustin L. Says:

    Yra- This is one of the themes that dominates my thoughts these days, as you may have been able to tell from past comments. This and the BOJ and JGB win-win short, but that’s a whole other conversation. Oh, and the ECB panicking about the Euro and the Bundesbank even starting to come around but probably slower than the market is assuming. Wait, I think I just repeated your point didn’t I ;) Will the rest of the world be pushed back into currency wars again as the US continues to steal demand that Europe, Japan, and the EM feel they can’t afford to give up? Will they continue to fight The Great Rebalancing until it enforces it’s own adjustments but much more chaotically? But, let the low vol roll as pricing in risk in an environment of easy money is for suckers apparently! ;) Long live the Fed! (It truly needs the best wishes to survive it’s balance sheet experiment)

  4. Dustin L. Says:

    and one must not forget about MP-http://blogs.ft.com/gavyndavies/2014/05/11/macro-pru-is-no-panacea/

  5. Dustin L. Says:

    The BOE could be an important indicator of the central bankers dilemma. Will the BOE blink first?

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