Even though some pundits continue talking about tapering, there's no doubt the talk itself has been tapering off recently. I will go one step further to say that if anything the probability of more stimulus -- in what I do not know) -- has increased in the last week.
More significantly, Treasuries, as shown by the iShares Barclays 7-10 Year Treasury ETF (IEF) and iShares Barclays 20+ Year Treasury ETF (TLT), have stopped their precipitous fall since May 29. Note that, for the last three sessions, equities resumed their traditional negative correlation with Treasuries and gold.But if the risk of any tapering has dcreased, shouldn't the stock market also go up? Not necessarily. Ultimately, the stock market reacts more to public companies' earnings outlook. Whether that outlook reflects economic reality or easy money is a different, and to a degree irrelevant, question. If the earnings outlook turns grim, the stock market goes down. Stimulus helps the stock market only when it becomes a high-probability event and the market expects it to help the outlook. With the market becoming increasingly aware of the diminishing return of QE, the link between stimulus and stock market surge will become weaker.
Treasuries, on the other hand, are directly linked to QE. Unless QE comes in some supertwisted form that involves the Fed selling Treasuries across the curve (bordering on the unimaginable but, given the desperate central bank monetary innovations of the past few years worldwide, I dare not rule out anything), at least some maturities will go down in yield. More important, inflation expectation has gone down since mid-March, and even broke down below the perennial 2% two weeks ago, as shown below in my favorite chart of 5Y CMT, TIPS and inflation expectation: Data from the Federal Reserve This is the first time the 5Y inflation expectation has been below 2% since the onset of QE3. From this annotated chart you can clearly see how the Fed's stimulus barrier has gradually increased in supporting inflation (becoming more ambitious) since the 2008 crisis. First the trigger was 1.2%, then 1.5%, and QE3 was announced when inflation expectation was above 2% and rising. Its going below 2% again is a clear failure of QE, especially in its current open-ended incarnation.
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