Monday, April 18, 2011

Macro volatility ahead

As the market holds its breath in anticipation of the results of the upcoming FOMC meeting and various Fed luminaries voiced concerns about rising inflation, it seems that QE3 is dead and there is a risk to the Fed's zero interest rate policy (ZIRP).

Notwithstanding Friday's headline CPI showed itself to be up 2.7% in the last twelve months, inflationary hysteria was further fanned when CNBC featured a story that showed the calculation, by, of CPI using the method used in 1980 to be an astounding 9.8%.

How will the Fed perceived inflation? I have no idea.

Given that the latest Beige Book shows an improving economy, the consensus seems to be that QE3 is off the table for now and ZIRP is threatened. The ECB, which does not have the dual mandate of the Federal Reserve, is already starting to tighten monetary policy despite the risks to the eurozone periphery.

Outlook is highly policy dependent
Meanwhile, the IMF warned that the US will have the largest fiscal deficit in the developed world and should take steps to deal with the problem now:
The U.S. is set to have the largest budget deficit among major developed economies and should narrow it now rather than face tough adjustments in the next two years, the International Monetary Fund said.

The U.S. shortfall will reach 10.8 percent of gross domestic product this year, ahead of Japan and the U.K., the Washington-based agency said in a report released today. It estimates that President Barack Obama will need to cut the deficit by 5 percentage points of GDP in the next two fiscal years, the largest adjustment in “at least half a century,” to meet his pledge of halving it by the end of his four-year term.
Throw in the bickering and horse trading over the debt ceiling - and future macro conditions are highly policy dependent. Needless to say, any fiscal tightening in the face of a fragile recovery could be deadly for the economy and markets.
I wrote in November 2008, at the height of the meltdown, that conditions were highly policy dependent and that there are no investment models for all seasons. It seems that nothing has changed.
Investors need to be prepared to weather this volatility, whether it is the use of tactical asset allocation such as the Inflation Deflation Timer Model, risk budgeting, or simply to raise some cash in order to keep some powder dry in preparation for better investment opportunities should the markets hit an air pocket.

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