Watch the Data, Buy on the Dip

NEW YORK ( TheStreet) -- Two weeks ago I questioned the widespread talk of the Federal Reserve cutting back or tapering its quantitative easing program.

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.

While equities, as seen by the SPDR S&P 500 Index ETF ( SPY), continued their two-week slide, gold, as shown in the SPDR Gold Trust ETF ( GLD) has been on a slow but steady rebound since May 18.

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.

Or perhaps the "taper" talk is just a failure of Fed communication. The Fed was the one that started it and now it has to fix it, fast.

Two scenarios before the FOMC meeting on June 18-19:
  1. New economic data strongly and consistently support the hypothesis of strong economic recovery, therefore driving the inflation expectation back up to 2.3% or higher. Given the decidedly mixed data so far, this is unlikely. But in this case the Fed may not do or say anything drastic.
  2. Mixed economic signals continue, inflation expectation stays below or fluctuates around 2%. This is likely, and the Fed would have to tighten the leash and stop the taper talk quickly. Some encouraging words, meaning a pessimistic outlook in today's world, may be said.

Considering the aforementioned recent market trends, and if you agree with my assessment of the probabilities of the two scenarios, it may be time to keep close watch of forthcoming economic data and buy the dip, gradually, in Treasuries and gold.

Or, if you want to wait, at least keep close watch of forthcoming economic data and get ready. Buying the dip in stocks is more risky -- as mentioned earlier, Fed words and even action may no longer be sufficient to boost confidence in the economy at this point.

International developments, perhaps now more than usual and especially from Japan and Europe, will also be crucial factors. Here's one bullish thing for Treasuries: new Chinese President, Xi Jinping, will visit the U.S. in June (exact date yet unknown but he's in Latin America now). Unless his meeting with President Obama turns out to be a disaster (highly unlikely), China will continue its recent increased pace of purchasing U.S. Treasuries.

At the time of publication the author was long GLD and TLT.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.