Taking it easy on June 20

This will not be a full-fledged QE3 because Dr Bernanke does not want to get crucified by the Republicans in an election year when the Democrat incumbent in the White House struggles with a succession of grim economic data. The Fed will do a modest extension of its Operation Twist, possibly also expand its balance sheet with the purchase of long duration US Treasury bonds and mortgage backed securities. My rationale for a Fed ease?

One, US growth outlook has begun to unnerve key FOMC policy makers. The April and May job numbers have made it clear that the labour market is deteriorating. New York Fed President Bill Dudley, a permanent voting FOMC member, identified labour market risks as a prerequisite for policy easing. After all, the three-month payroll gain was 252,000 as recently as in February. This crucial data average is now below a dismal 100,000 now. The Fed’s dual mandate will force the FOMC to act now that inflation risk is not an issue!

Two, global growth poses a major source of recession risk to the Europe. The Spanish sovereign debt spiked to seven per cent after the latest EU bank bailout and mayhem after the Greek election is all too possible. China, India and Brazil growth rates have plummeted, a major risk for US exports to emerging markets. The world economy, not just US payrolls, are a source of recession risk.

Three, the Chinese lending rate cut increases my conviction that the Federal Reserve will move in June. The People’s Bank of China and the Fed, after all, are the de facto central banks who manage the planet’s yuan-dollar monetary blocs. When Beijing moves, Washington will follow.

Four, the $30 fall in Brent crude has a major downside impact on inflation risk and inflation expectations. This is all the more true given the strength in the US Dollar Index, a deflation risk. The Fed can focus on growth, not inflation.

Five, the Fed has become far more sensitive to spikes in Spanish/Italian government bond credit risk relative to German Bunds. This makes sense since the American central bank is the planet’s de facto lender of the last resort and the Club Med spreads can threaten new issuance/liquidity in the world’s credit markets.

The Fed is haunted by the ice age in global credit after the failure of Lehman Brothers. So it needs to take out Greece insurance with a preemptive, if modest, ease. In any case, the FOMC statement reiterated an easing bias in May and regional Fed Presidents have voiced dissent with a bias for easing. If I am right, on June 20, Treasury bond prices plunge, the dollar falls, oil/gold and commodities currencies rise (love to buy Canada at 1.03 against the dollar), as does the stock market. At least for the day (June 20)!, I still believe the ten year US Teasury note is grossly overvalued at a 1.60 per cent yield.