Fed QE3 is Moving Closer - Forex Analysis, Currency Forecast, FX Trading Signal - Action Forex

CHICAGO--Eurodollar options traders on Thursday signalled that a key interbank lending rate is expected to rise in the wake of the first settlement surrounding allegations that it was manipulated by financial institutions.

The Eurodolar market is the largest asset class tied to three-month London Interbank Offered Rate, or Libor, which banks charge each other to borrow U.S. dollars.

We have discussed at length the need for the equity market to be significantly lower in order for Bernanke to step in with his munificence. Critically, this is less about the absolute level of the S&P 500 (though anyone expecting the Fed chairman to step in with the S&P 500 within a few percent of multi-year highs is dreaming) but, as Barry Knapp from Barclays notes - based on Bernanke's writings - additional monetary stimulus is a function of a significant drop in inflation expectations (as opposed to a shallow drop in the S&P 500). It is the risk of deflation that will trigger a policy reaction. Current conditions are not even close to levels that have warranted additional stimulus in the past - which we estimate to be a 2% 5Y5Y forward inflation breakeven rate. In order for that level to be triggered - based on the post-crisis relationship between equities and inflation expectations - the S&P 500 trailing earnings yield would need to rise over 8.2% implying an S&P 500 level near 1200. Tracking inflation expectations is critical to any NEW QE hope - and for now, there is none on the horizon, no matter how much everyone clamors for it.

The trigger for previous extreme monetary easing has been around the 2% level (red dotted line) for 5Y5Y inflation breakevens...



The small red and green arrows above (as we noted in a previous post) show the risk flare around Europe's initial re-emergence into crisis which was quickly grabbed as managers bought the dip on the Bernanke Put hope.

This implies around an 8.2% trailing earnings yield or an S&P 500 level around 1200...



Simply put - without break-evens dropping, the Bernanke Put will not arrive (as the printer-in-chief would implicitly believe it to be too inflationary) and so asset values will need to fall (on the back of real earnings disappointment or fundamental macro deterioration) in order to bring the FOMC in - if the status quo of BTFD reflexive front-running continues, NEW QE will remain absent.

Data/Charts: Bloomberg

The major problem with daily jawboning by central bankers, such as Draghi today, and the Fed via Hilsenrath on Tuesday, is that it "achieves" to price in QE without QE actually being implemented: in essence the various central banks try to run up assets on the rumor, knowing well that with every incremental "news" event, the news will be sold ever faster, and ever more forcefully. Which then begs the question: how much QE is currently priced in, in order to determine how much more "rumor" there is to buy. According to Bank of America: not much, as a full 65% of QE 3, or the NEW QE, to use the proper iNomenclature, is by now priced in.

Here is BofA's take:



There are a few key differences between now and the past two balance sheet expansions: 1) Fiscal policy is likely to be tightening rather than loosening. 2) Global growth is much weaker. 3) The dollar is unlikely to weaken as much as it did during QE2 given the escalation of the euro zone debt crisis. 4) The realization that previous rounds of QE have not been able to stoke a stronger and more sustained economic recovery.

The market implications of QE3 will likely be a function of what is priced in by the time it is announced. Currently our model (see here for description) estimates that 65% of QE3 is priced in (Chart 8). This is much lower than before QE2 was announced. Therefore as the Fed sends stronger signals of QE3 in the near term we expect more downward pressure on yields. However, we believe that by the time QE3 is announced, the market will likely have priced it in.

Needless to say, when the Fed itself become the ultimate "sell the news" event, and the credibility of the only remaining real backstopper in town is gone, one does wonder: what then? But at least it explains why both Ben and Mario will do everything in their power to extend the period of simple jawboning without actually hitting CTRL-P.

Could we hit a point when over 100% of the NEW QE is priced in then? Why of course.