No fewer than four Regional Fed Presidents are due to speak this week, plus Bernanke, and they represent a pretty wide spread of hawks, doves and centrists, so we should be able to watch their lips to get a better sense of whether the bond market was correct in its surprisingly large response to Friday's suspect US unemployment report.
My gut feeling is that this bond market sell-off should be faded. Already this weekend Chairman Bernanke has observed that the unemployment rate understates labour slack in the economy and I feel we may finally be witnessing the acceleration of a slide into deflation in developed economies. After a shock to the system as large as the credit crisis, perhaps the real surprise is that this has taken so long to become evident. The scale of the inevitable deleveraging process that was always going to have to take place would classically suggest this outcome, but then we have to add to the mix the fact that the Eurozone (13.5% of global GDP in 2012) is saddled with a massively deflationary economic experiment, in the shape of the Euro.
This is the chilling conclusion one might draw from the fact that even the ECB has now got the message and has begun to reinforce its forward guidance that rates will still be at present levels or lower for a considerable period of time. Yet even now we didn't get the Full Monty - a move to negative deposit rates is what the peripheral countries now need desperately. Before they joined the Euro they would have been able to regain some degree of competitiveness via devaluation. Now the only way out for them is mass, long-term unemployment while structural reforms to their labour markets take hold-if they ever do. A cut in the ECB deposit rate would begin to seriously weaken the Euro, replicating the pre-Euro solution for the periphery.
One has to say the whole thing is becoming painfully reminiscent of the Bank of Japan's failure to take bold steps in the face of the imminent arrival of deflation.
A monetary union without a fiscal union, combined with the aftermath of a credit splurge and then vicious retrenchment such as we witnessed, was always going to imply such austerity and unemployment in the periphery that deflation was the inevitable denouement. This is now spreading even to the core. This week's CPI figures in Germany and France will be absolutely key. Japanisation is the real danger for Europe now, and the same could start to be true in the US too, unless we see an uptick in core inflation soon.
Although the establishment survey, part of Friday's US employment reports (the non-farm payrolls), certainly contained some crumbs of comfort (forget the household report which contains the headline employment rate as it was totally corrupted by the effects of the government shutdown), I find it hard to believe the balance of views on the FOMC will be sufficiently shifted by one set of figures, or even just by the hopefully untainted report next month, to bring tapering forward to the December meeting . Optimists also latched onto last week's first reading of Q3 GDP, at +2.8%, as another positive, but the bulk of the surprise came from a large increase in inventories - always a double-edged sword. Were inventories climbing because of falling demand right now, or because manufacturers foresaw increased demand in the future? Either way the likely give-back in this quarter means growth is heading for only 1.5% in Q4.
Finally though, Fed politics also mitigate against December tapering. It seems pretty clear that QE is seen as yielding diminishing returns and the monetary tool du jour is now forward guidance (love it, or think it's dangerous like me), and the Fed would like to strengthen theirs by lowering the employment threshold for rate rises from 6.5% to at least 6.0%, probably 5.5%. This is a normal human reaction to the scare of their lives that the Fed got this summer as 10-year yields exploded from 1.6% to 3.0%, slowing the housing market and dragging higher the shorter term rates that the Fed would have us believe are anchored for years to come. I believe we won't now see QE without this enhancement of forward guidance.
With a change of Chairman coming up and wholesale changes in Fed voters six weeks after the next Fed meeting (both Regional President rotations and new Fed Governors), this strengthening of forward guidance will look very suspect if it takes place in December and is just inherited by the 'new' FOMC in January. Forward guidance is, by definition, a promise of a very personal nature.
Watch out for CPI on 20 December and core PCE (Personal Consumption Expenditure) deflator (the Fed's preferred measure) on 6 December (same day as November non-farm payrolls), as last month the latter fell to 1.2% Y.o.Y., to judge the proximity of deflation in the US. This time last year it was 1.7%.