Dovish FOMC Minutes Indicate QEII Will Run Its Course. Market on Data Watch

By: • Wed, Jan 5 2011, 8:37 AM

The Fed seemed to soothe bond buyers yesterday with generally dovish FOMC Minutes. Dovish = low inflation, low interest rate environment.

While the underlying tone was indicative of segmented strength within the economy, optimistic outlooks were clearly hampered by poor labor market conditions, excessive slack in resource utilization, and housing, housing, housing. Plus political strife and debt concerns among EU nations were listed as a potential thorn in our side. One thing that was noticeably absent from Fed's view of the economy was.... inflation. They did acknowledge rising energy and food prices but also said producers had little room to pass along these higher costs to bargain hunting consumers. I guess only time will tell who wins that tug-of-war (coughMARGINPRESSUREcough....for Consumers and Producers). So much for demand pull inflation!

That just about sums up the FOMC Minutes. The December FOMC Statement was almost identical to the November statement in terms of economic rhetoric. The market was really only looking for the Fed's commentary on its bias toward MORE or LESS quantitative easing. This is what the market got in response...

While the economic outlook was seen as improving, members generally felt that the change in the outlook was not sufficient to warrant any adjustments to the asset-purchase program, and some noted that more time was needed to accumulate information on the economy before considering any adjustment. Members emphasized that the pace and overall size of the purchase program would be contingent on economic and financial developments; however, some indicated that they had a fairly high threshold for making changes to the program.

I took two things from that statement...

Look for markets to trade tactically around influential data releases. This means we should see more "buy the rumor, sell the news" frontrunning market behavior around important economic events such as the Employment Situation Report
Even if economic data continues to improve (segmented), the labor and housing markets are in need of major structural repairs, thus it makes sense that some members have indicated a "fairly high threshold" aka willingness to let QEII run its course as planned.

Plain and Simple: The Fed is playing chess not checkers. It seems like QEII will be left to run its course.

Also of note in the FOMC Minutes....the Fed's perspective on the post-QEII run up in rates...

The decision to expand its holdings of longer-term securities by $600 billion by the end of the second quarter of 2011 was also roughly in line with market expectations, although market participants appeared to expect the purchase program would be increased over time. In the weeks following the November meeting, yields on nominal Treasury securities increased significantly, as investors reportedly revised down their estimates of the ultimate size of the FOMC’s new asset-purchase program. Incoming economic data that were viewed, on balance, as favorable to the outlook and news of a tentative agreement between the Administration and some members of the Congress regarding a package of fiscal measures also reportedly contributed to the backup in yields. Market participants pointed to abrupt changes in investor positions, the effects of the approaching
year-end on market liquidity, and hedging flows associated with investors’ holdings of MBS as factors that may have amplified the rise in yields.

Notice the Fed said nothing about an INFLATION PREMIUM in bond yields. This sounds a whole helluvalot like WHAT WE SAID HERE. QEII was a perfect example of the market "buying the rumor and selling the news". Mutter mutter....