http://blogs.ft.com/gavyndavies/2013/05/23/falling-inflation-complicates-the-feds-qe-exit-plan/

“This article shows that deflation remains a significant risk and QE exit may be further away than perhaps many are thinking. If so, what are the implications for various asset classes and indices?"

Eoin Treacy's view Thank you for this interesting article and question which is sure to be of interest to subscribers. Here is a section from the article:

After a long period in which Fed economists were struggling to explain why inflation has remained so high, given the amount of slack which remained in the labour market, they now say that part of the recent decline in inflation has occurred for temporary reasons. No-one thinks deflation is very likely, but the doves will take the 18-month long slide in PCE inflation seriously, even though it has not yet unhinged inflation expectations from the 2 per cent target. In Mr Dudley's words, “deflationary expectations can be self-fulfilling in driving actual deflation outcomes.”

After yesterday's evidence, it is clear that the Fed's decision on tapering will be “data determined”. But the relevant data include inflation reports as well as employment reports. The Fed is now missing both parts of its twin mandate in the same direction. This will complicate, and perhaps delay, the decision on when to start tapering QE.

Let us take for granted that as money managers strive for relative performance they will use every tool available to achieve their goal. Since the Fed is engaged in increasing the supply of money and supporting the Treasury and mortgage markets via quantitative easing we can assume that at least some leveraged traders will have taken the most possible advantage of this situation. They are likely to maintain their positions until a change to the monetary environment is discernible. So how does this fit with the Fed's policies?

As I mentioned yesterday, the Fed has seen progress on the economic front. Much of this is not measured by unemployment or inflation. Asset prices, not least housing, have improved, the consumer has deleveraged somewhat and consumer sentiment is improving. The economy's competitiveness has been enhanced and the USA remains a favourable investment destination not least because of comparatively low energy prices. Therefore the Fed is treading a fine line between the effect liquidity has on asset price inflation and the need to combat stubborn deflationary pressures and promote full employment.

The removal of QE1 resulted in a sharp pullback. The removal of QE2 resulted in an even sharper pullback. We should also remember that the introduction of QE on all three occasions resulted in powerfully persistent rallies. At present the Fed is not talking about removing QE but is considering reducing the amount added to the market on a monthly basis. From the perspective of leveraged trading strategies, the difference is mostly academic. They would need to adjust position sizes if the availability of the liquidity on which they depend for funding is curtailed.

If QE3 is to be tapered at least some leveraged traders will be pressured. The effect of a removal of QE, which is not a near-term prospect, would be greater. Without engaging in conjecture, if we focus on the chart facts, a short-term overbought condition is evident on a number of markets, not least the S&P500. The potential for a consolidation of recent powerful gains has increased but mean reversion probably represents the worst case scenario at this stage for the majority. A drop below 1600 will be required to confirm more than a near-term peak for the S&P

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Euro-Area Services, Factory Gauge Rises More Than Estimated – This article by Svenja O'Donnell for Bloomberg may be of interest to subscribers. Here is a section: