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What the Fed Is Watching

NEW YORK ( TheStreet) -- Risk-asset markets experienced their first bout of volatility this week, which had been largely absent for a better part of the year.

The two strongest underlying factors that have been driving up equity markets have been central bank liquidity and the strength of corporate earnings.

But now, corporate earnings reports are mostly done for the quarter, which leaves central bank aid as the lone support system. Although economic data have trended higher, data releases remain volatile from one month to the next.

After Federal Reserve Chairman Ben Bernanke spoke last Wednesday and introduced uncertainty about the continuation of quantitative easing, equity markets began pulling back.

In an effort to calm market fears, Federal Reserve governors came out on both Thursday and Friday to clarify that quantitative easing would not be reined in in the short term.

Inflation must tick higher, and unemployment, as well as the labor force participation rate, must improve before the Fed deems the economy healthy enough to operate on its own. The indicators below show that monetary policy is not likely to be tightened in the near term.

The first chart is of Barclays TIPS Bond Fund (TIP) over Barclays 7-10 Year Treasury Bond Fund (IEF). This pair measures inflation expectation, and correlates strongly to CPI readings.

The chart is nearing yearly lows, indicating that the market does not fear rising inflation. As long as the indicator remains at suppressed levels, the Fed will take this as a sign for further action. An improved economy will bring about higher inflation expectations, which in itself should be a virtuous circle of improvement.

The next pair is SPDR Gold Trust (GLD) over the DB Commodity Index Tracking Fund (DBC).

This pair measures the relative strength of gold vs. the broader commodities sector.

Gold is an inflation hedge that acts as a substitute to paper assets. When inflation is no longer a concern, hedging becomes less of a necessity. The pair has broken lower in recent weeks to a multiyear trough.

Investors in other countries, whose currencies are currently being devalued, are actively choosing to hedge their currencies' weakness by buying dollars. If your currency is being devalued against the dollar, then why not buy the dollar, and invest in U.S. equities? As the dollar continues to strengthen and equities keep their status as the most attractive asset class, gold will be persistent in its decline.

The last pair is Total World Stock Index ETF (VT) over the SPDR Gold Trust. This chart measures investors' attitudes in the battle between world equities vs. gold.

As central banks have actively devalued their currencies beginning in late 2012 and inflation has become less of a fear, equities have drastically outperformed gold.

Hedging weaker currencies by buying the dollar, as well as investing in equities, has pushed this pair higher. As long as monetary policy remains accommodative and inflation fears are subdued, risk assets should continue to outperform.

At the time of publication, Sachais had no positions in securities mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
Andrew Sachais' focus is on analyzing markets with global macro-based strategies. Sachais is a chief investment strategist and portfolio manager at the start-up fund, Satch Kapital Investments. The fund uses ETF's traded on the U.S. stock market to gain exposure to both domestic and foreign assets. His strategy takes into consideration global equity, commodity, currency and debt markets. Sachais is a senior at Georgetown University earning a degree in Economics.

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