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"They're Converging To Dire Levels!": SocGen's Edwards Delivers Critical Warning On Inflation Expectations

At a certain point, one has to wonder if there will ever be a time when developed market policy makers throw in the towel. 

When both Japan and Europe slid back into deflation lately, it served notice that trillions upon trillions in central bank asset purchases are definitely not working to restore confidence in the global economic recovery and/or reinvigorate inflation expectations. 

However, you cannot simply print trillions in paper liabilities in order to purchase your own other paper liabilities (and no, that is not a typo, that’s just simply what’s happening here) without creating distortions across capital markets and that’s exactly what’s happened across the globe as the Fed and its DM brethren have "accidentally" engineered an epic case of capital misallocation that, far from promoting an increase in global demand and trade, has actually contributed to a global deflationary supply glut. 

That is actually not nearly as complicated as it sounds. Put simply: if you keep uneconomic businesses in business, you also keep their supply online, which means that at the end of the day, if the fiat money you’re injecting doesn’t end up trickling down and stimulating aggregate demand because the NIM margins of the banks you’re giving it to are so low thanks to ZIRP as to discourage them from sharing the wealth, well then, all you’ve actually done is create a scenario where the idea of inflation expectations is essentially meaningless right up until everyone wakes up to what’s going on, and then it’s Weimar time. 

So consider all of that, and then consider the following from SocGen’s Albert Edwards who has some characteristically introspective commentary regarding the interplay between central banks and inflation expectations and generally does a nice job of explaining what we’ve been at pains to point out for months (if not years): namely that central bankers are largely hapless when it comes to achieving their stated goal of rescuing their respective economies from the deflationay doldrums.

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From SocGen

Two things caught my eye this week. The first was more soggy Japanese economic data which suggests that the BoJ may soon hit the QE button even harder. That would trigger a renewed slide in the yen and another round of Asian currency turmoil – plus c?a change! But, secondly and perhaps more important is increasing evidence of a loss of confidence that the Fed is actually in control. Ignore for a moment the stock market’s celebration of weaker than expected payrolls. Instead investors should focus on the rapid decline in US inflation expectations since the Fed meeting – even now converging to dire eurozone levels!

Expectations of the first Fed rate hike were kicked into March next year in the wake of the weaker than expected payroll release. We?ve been here before and it?s becoming tedious. But at least the equity market?s euphoric reaction was entirely predictable.

Far more interesting is the continuing slide in US break-even inflation expectations. The measure for 5y expectations, in 5 years time, has now decisively fallen below the January low (see chart below) and the spread verses the eurozone has now fallen to only 20bp against 60bp last October. Bond investors are signalling to us that they don?t believe the Fed is in control anymore. The Fed by contrast is brushing aside the market?s deflation concerns. It all feels very much like Japan circa 1995 in the wake of the yen?s then surge.

Talking about Japan, we are at a crucial crossroads. Most observers, except perhaps the BoJ and the Abe government, believe the economic data has been disturbingly weak. Most therefore expect the BoJ to crank up QE, or QQE as it is known in Japan ? having added a wishful qualitative to their quantitative easing. You know my view. All this money printing will ultimately end in tears. Despite being a fully paid up member to the school of thought that believes that Japan has no option other than to monetise its public sector deficit because the government is insolvent, that is also the same reason why I remain bullish on the Nikkei. Japan?s massive QQE (many times that of the Fed and ECB) is the steroids that mean Japan should outsprint all other runners in this currency race to the bottom. And when the yen renews its slide, expect round two of Asian emerging currency weakness to begin and US and eurozone inflation expectations to head lower still.

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There are two takeaways here, the first is from Edwards and the second from us.

From SocGen:

The collapse in inflation expectations tells us that the market believes the central banks, despite their monetary profligacy, are failing to prevent the western economies from turning Japanese, and thus at risk of repeating their devastating slide into outright deflation in the 1990s. 

And from "The Unwind Of QE Means The "S&P Should Be Trading At Half Of Its Value", Deutsche Bank Warns":

In his latest weekly note, DB's derivatives analyst Alekandar Kocic focuses on the interplay between US inflation expectations and US equities, and points out something curious, and very much spot on:

Policy response to the crisis post-2008 consisted of unprecedented injection of liquidity, transfer of risk from private to public balance sheet, and reduction of volatility from its toxic levels. The net result was near-zero rate levels and collapse of volatility across the board, while different market sectors developed high degrees of coordination. The last effect has been an indirect result of the central banks’ flows and the distortions they introduced in the bond market. In this environment other markets acted as a complement to rates (through which monetary policy was transmitted) and crowding out there pushed investors to articulate their views elsewhere. Their participation was a function of amount of liquidity injection. As a consequence everything was trading off of US inflation expectations as the main expression of the QE effects.

That was the case for the first 5 years of "unconventional policy" until some time in 2013. Then something snapped. Kocic continues:

With deflation as the main risk tackled by monetary policy, its success or failure was gauged by the ability to reflate the economy. Inflation expectations and breakevens were therefore signals for risk-on or risk-off trade. In fact, most market sectors, from FX to EM equities, were trading in high coordination with breakevens. Taper tantrum was the end of these correlations and a beginning of dispersion across different assets. In effect, it was the unwind of the “QE” trade, its first phaseWhile most other assets, like credit spreads, EM equities or different currencies, do not have a logical connection with US breakevens, US equities do. The dispersion between these assets and breakevens was an expected consequence of policy unwind. However, for US equities this unwind distorted their “natural” correlation with inflation. Persistence of these dislocations is just a manifestation of to what extent QE has been an important driver of post-2008 markets.

Which brings us to the punchline:

Since 2013, stocks rallied while disinflationary pressures were reinforced by a strong USD, low commodity prices and a decline in global demand. If pre-2013 coordination between the two is taken as a reference, then based on current stock prices breakevens should trade about 1.5% wider. This means the Fed should be hiking because inflation is above target. Alternatively, given the current level of inflation, S&P should be trading at half of its value.

Wait, the S&P should be trading at 900... or even less? Yes, according to the following Deutsche Bank chart:

Only one question remains: which breaks first - do inflation expectations surge higher, soaring by some 150 bps to justify equity valuations, or do equities crash?

Is reconciliation likely – and, if so, in which direction? Are we returning to the pre-crisis world, or we are in a completely new regime?

The answer will come from none other than the Fed and by now, even Janet Yellen knows that one word out of place, one signal to the market that the QE-inflation trade will converge with stocks crashing instead of inflation rising (which, unless the Fed launched QE4, NIRP of even helicopter money now appears inevitable), and some $10 trillion in market cap could evaporate overnight.

Is it any wonder that Yellen is exhibiting "health issues" during her speeches: the realization that the fate of the biggest stock market bubble lies on your shoulders would make anyone "dehydrated."

In retrospect, Ben Bernanke knew exactly what he was doing when he got out of Dodge just as the endgame was set to begin.