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The Global Radar Screen 05/20/11
[private][private]Overview—Judgment Day Delayed
In the U.S., stocks and bonds are been in a holding pattern for the past two weeks, with the bond market holding on to its recent gains. The bond market in particular is trading that the judgment day on the Fed is later rather than sooner. First, the rebound in the Q2 seems pretty soggy, with few forecasters willing to pencil in more than 3% GDP growth after only 1.7% in Q1. Even the Fed thinks that the downside risks outweigh the upside risks to the outlook. Second, the FOMC minutes indicate policymakers are contemplating a complicated and lengthy exit sequence which starts with stopping QE2 in June and freezing the balance sheet over the summer. After that, at a time yet to be specified, passively shrinking the balance sheet, draining reserves to help set up the corridor system, explaining they are finally ready to hike rates by altering the “low for long” language, then (after skipping at least one FOMC meeting) hiking policy rates, and finally actively selling assets with the goal to getting to a mainly Treasuries portfolio within five years. While DE is carrying a below consensus GDP forecast of less than 3% for the remainder of 2011, a rising core inflation rate will persuade the Fed to hike rates sometime in 2012H1, which implies the passive reduction in the balance sheet may begin as early as late 2011. Some others do not expect a formal rate hike until 2013. All this suggests that interest rates could remain quite low, pinned down by a Fed in no hurry to start exiting as long as the recovery seems soggy. This complacency about low rates could change in a hurry, particularly if Washington policymakers cannot come up a debt ceiling extension this summer or more importantly, at least a rough outline of what they would do after the 2012 election to achieve a sufficient amount of medium term fiscal consolidation.