Saturday, April 9, 2011

Inflation Expectations Continues to Heat Up




As a follow up to a recent post about how the bond market is worrying about inflation, I post these charts. The top chart shows the relationship between 5-yr TIPS and 5-yr Treasuries, with the spread between their real yields (which equates to the market's expectation for the what the CPI will average over the next 5 years) now within a few bps of an all-time high (2.85%). The second chart does the same for 10-yr maturities, and the spread there has now reached 2.63%, which is also very close to its highest level since 2005.

The message of both charts is the same: inflation expectations are rising significantly. Fed supporters would be quick to note that this could just be a rational reaction to the recent and continuing rise in oil prices. But Fed critics have more ammunition: the very weak dollar, the broad-based rise in commodity prices, the all-time highs in precious metals, and the substantial rise observed to date in the producer price indices and the ISM prices paid indices. There is no shortage of evidence that monetary policy is extremely accommodative and inflation pressures are building. The last refuge of the inflation doves (the Phillips Curve theory of inflation) is being dismantled almost daily, as prices all over the world rise even as there remains plenty of slack in the U.S. economy.

To his credit, Dallas Fed President Richard Fisher today sounded a pretty strident inflation alarm: "Inflationary impulses are gaining ground in the rest of the world ... this will result in some unpleasant general price inflation numbers in the next few reporting periods ... there is the risk that we might breach our duty to hold inflation at bay."

I think it is now clear that the Fed has way overstayed its welcome with QE2, and I find it hard to believe that the rest of the Fed governors will ignore the mounting evidence of such. The ECB has already made the first move to tighten, and meanwhile the figurative rats are abandoning the sinking USS dollar (see my prior post on Brasil). QE2 is scheduled to finish in a few months, but if it is abandoned now it will hardly be cause for concern, since the remaining Treasuries to be bought represent only a very tiny fraction of the total outstanding, and thus are very unlikely to make much of a difference to yields and/or the economy. What will make a difference, of course, is a Fed decision to ignore the evidence of rising inflationary pressures.

Reserves May Ignite Much Higher Inflation As Banks Ramp Up Lending

by Scott Grannis at Calafia Beach Pundit blog:
 
Even as the evidence of rising inflation expectations mounts, it's important to not lose sight of the bigger monetary policy picture. The Fed has taken some extraordinary measures to ensure that the U.S. and world economies do not have to struggle with any shortage of liquidity. That involved the purchase of almost $1.5 trillion worth of MBS and Treasury notes. But the popular perception that they have expanded their balance sheet by printing massive amounts of new money (aka monetizing the deficit) is incorrect. Yes, they have created massive amounts of bank reserves, but almost all of those reserves are still sitting on the Fed's books—they have not been turned into newly printed money. The world probably has too many dollars, as suggested by the declining price of the dollar and the rising prices of gold and commodities, but the excess of dollars is not measured in trillions.

As I explained in a prior post, the Fed has not printed $1.5 trillion of new money—they have simply swapped $1.5 trillion of bank reserves for $1.5 trillion of notes and bonds. The bank reserves they have created are functionally equivalent to 3-mo. T-bills, and thus are viewed as among the very safest of asset classes on the planet. The Fed has apparently satisfied the world's demand for safe cash equivalents. By swapping reserves for notes and bonds, the Fed also has effectively shortened the maturity of outstanding Treasury debt. They haven't monetized the debt, they've shortened its maturity. That may well prove to be a very imprudent move from the government's perspective, especially if interest rates rise significantly, but it will shift a meaningful portion of the mark-to-market losses on notes and bonds in a rising interest rate environment away from the private sector and onto the Fed's books. Our government, and ultimately, taxpayers, are now more exposed to rising interest rates, whereas institutional investors are less exposed.

The charts that follow demonstrate that the only extraordinary result of the Fed's extraordinary actions has been an extraordinary increase in bank reserves. All other measures of the money supply are behaving within the range of historical experience. 


Bank reserves have increased by $1.4 trillion since September, 2008, when the Fed first began to implement its Quantitative Easing program. About $400 billion of that increase has occurred since QE2 began last November.



The Monetary Base (which consists of bank reserves and currency in circulation) has increased by about $1.6 trillion since quantitative easing started. $1.4 trillion of that increase represents bank reserves, and most of the remaining $200 billion consists of an increase in currency in circulation. As the second chart above shows, the growth of currency has not been exceptional at all when viewed in an historical perspective. In fact, currency growth was much faster during the 1980s and 90s, when inflation was generally falling. The most important fact to remember when it comes to currency is that the Fed only supplies currency to the world on demand. The Fed does not print up piles of currency and then dump them into the world. People only hold currency if they choose to hold it; excess currency can be easily converted into a bank account at any bank, and the Fed must absorb any unwanted currency at the end of the day, since banks are free to exchange unwanted (and non-interest-bearing) currency for interest-bearing reserves, and would be foolish not to.


The M2 measure of the money supply includes currency, checking accounts, retail money market funds, small time deposits, and savings deposits. As the chart above shows, M2 has been growing about 6% per year on average, after experiencing a "bulge" in late 2008 and early 2009 that was caused by an exceptional increase in the public's demand for liquidity. If banks had been turning their extra reserves into newly-printed money (which our fractional-reserve banking system allows), then M2 would be growing like topsy: $1 trillion of new bank reserves could theoretically support about $10 trillion of new M2 money, and nothing like that has happened.

So, at the end of the day, about all that has happened is that the Fed has exchanged about $1.4 trillion of bank reserves for an equal amount of notes and bonds. No new money has been created in the process, beyond that which would have been created in a normally growing economy with relatively low inflation.

That's not to say that banks will forever allow their reserves to sit at the Fed. In fact, banks appear to be stepping up their lending activities to small and medium-sized businesses, but these actions are still in the nature of baby steps. If the Fed fails to take action to withdraw unwanted reserves in a timely fashion, or to somehow convince banks to leave their reserves on deposit at the Fed, then we could have a real inflation problem on our hands. But that remains to be seen. The weak dollar and rising commodity and gold prices suggest we are in the early stages of a rise in the general price level that, in turn, would equate to a rise in inflation to, say, 5-6% per year. If banks begin to turn their reserves into new money in a big way, then we could potentially see inflation rise well into the double or even triple digits.

Allen Meltzer yesterday proposed one solution to this potential problem in yesterday's WSJ: "The Fed Should Consider a Bad Bank." He suggests that the Fed simply transfer all the extra reserves to a separate bank where they would be held until maturity, and thus unavailable to the banking system. I think it's also possible that the Fed could sell a significant portion of its reserves, by effectively reversing the swaps that created them in the first place. Would banks, and the financial system they serve, be willing to swap their risk-free reserves for notes and bonds? They might, especially if interest rates rise by enough, and if the world sees that the Fed has embarked on a viable exit strategy that will avoid totally undermining the value of the dollar.

The monetary policy picture is far from clear, and it is still potentially very disturbing. But it is not impossible or even catastrophic, not yet.

ECRI Says Inflation on Verge of Taking Off!

(ECRI) - In early March, former Fed Chairman Alan Greenspan was asked to comment about ECRI's long-held criticism that the Fed is chronically behind the curve on monetary policy because its forecasting models are based on core inflation and the output gap, rather than forward-looking inflation indicators.


Mr. Greenspan agreed with our critique of both the output gap and core inflation. First, he acknowledged, “I have always been somewhat skeptical about the output gap… The bottlenecks with the system are never captured obviously by that… So it’s not an infallible indicator.” On the usefulness of core inflation, he then went on to say: “But more importantly the general presumption of core is that oil and food fluctuate, but have no trend. That is incorrect.”

Finally, he asserted that the Fed also watches forward-looking inflation expectations and could thus forecast inflation no better – but no worse – than ECRI. He went on to say, “The problem is, none of these indicators will tell you when inflation is about to take hold.”

With respect, Mr. Greenspan is wrong.

By using good cyclical indicators, you can – and we do – correctly forecast when inflation is about to take hold.

And it’s precisely because the Fed – first under Mr. Greenspan and now under Mr. Bernanke – adamantly believes that inflation turning points can’t be predicted, that the current U.S. recovery stands in danger of being snuffed out prematurely.

ECRI’s future inflation gauges – which, unlike econometric models, monitor the evolution of self-feeding cycles in inflation – are designed to do just what Mr. Greenspan says can’t be done. Specifically, they are more direct measures of underlying inflation pressures that signal the timing of upcoming inflation cycle turning points. In fact, they also anticipate inflation expectations.

Mr. Greenspan says that by watching inflation expectations the Fed can forecast inflation no better – but no worse – than ECRI, yet the real-time records are quite different. This disconnect underscores a fundamental misconception among policymakers, that because inflation expectations can’t anticipate inflation cycle turning points, it can’t be done. Over the past decade, such misperceptions have led to serious errors in monetary policy timing.

For instance, in June 2003, the Fed cut rates to 1% as “insurance” against deflation, when, based on our Future Inflation Gauge (FIG), we had ruled out any deflation risk. The housing bubble then inflated further, and commodity prices rose.

In June 2008, six months after the recession began, a hawkish Fed was telegraphing rate hikes exceeding 100 basis points by year-end, according to the Fed funds futures markets. At that time, the forward-looking FIG was indicating the absence of any sustained inflation threat.

Just last summer, blindsided by a growth slowdown clearly foreseen by our leading indexes, the Fed abandoned its “exit strategy” rhetoric. Doing an about-face, it launched the second round of quantitative easing to guard against a newfound “tail risk” of deflation. Again, the FIG offered a different conclusion, having ruled out any deflation risk by late 2009.

The Fed’s ongoing reliance on inflation expectations, along with core inflation and the output gap – which Mr. Greenspan agrees don’t work – strongly implies that they have no workable tools to decide when to pull back on stimulus. Their incoherence about policy timing is rooted in the belief expressed by Mr. Greenspan that forward-looking indicators of inflation can’t tell when inflation is about to take hold.

Mr. Greenspan and his successor, Mr. Bernanke, are top-notch economists in an echo chamber where they are surrounded by other economists, who all tend to believe, deep down, that the best forward-looking information must be found in market prices. This is an economist’s mistake. Even in the face of compelling evidence that markets aren’t the best predictors of what’s around the bend, it’s really hard for economists to abandon their basic world-view.

This keeps the Fed chronically behind the curve. The “insurance” taken out by the Fed has been far from costless, especially in terms of the collateral damage from unintended consequences. Yet, damaging as it might have been in the past, the sheer size of the Fed’s current balance sheet makes it more critical than ever to improve the timing of monetary policy shifts.

As U.S. economic growth begins to revive, the long-term jobless rate, which is still around record highs, remains a festering sore. However, it’s obvious from a scrutiny of past cyclical patterns that only a long economic expansion – like those in the 1980s and 1990s – can heal that wound.

Central bankers need to stop clinging to policy orthodoxy and pay attention to proven cyclical leading inflation indicators that can actually tell them when inflation is about to take hold. Otherwise, if a well-meaning Fed stimulates the economy for too long, it will let inflation and/or asset prices get out of control, fostering boom-bust cycles that keep long-term unemployment at elevated readings as each short boom ends with a bust that pushes the jobless rate back up.

So, if the FIG takes off, watch out!

John Mauldin on the Road Ahead

as usual, great piece:

TWO roads diverged in a yellow wood,
And sorry I could not travel both
And be one traveler, long I stood
And looked down one as far as I could
To where it bent in the undergrowth;

Then took the other, as just as fair,
And having perhaps the better claim,
Because it was grassy and wanted wear;
Though as for that the passing there
Had worn them really about the same,

And both that morning equally lay
In leaves no step had trodden black.
Oh, I kept the first for another day!
Yet knowing how way leads on to way,
I doubted if I should ever come back.

I shall be telling this with a sigh
Somewhere ages and ages hence:
Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference.

– Robert Frost
“I shall be telling this with a sigh,” and it is with a sigh that I write about the twisting, uncertain roads of inflation and deflation. Long-time readers know I have made hard arguments for first deflation and then inflation in the US. But the data says the Fed is not seeing around the bend in the inflationary road all that well. Their signs are not giving them warning, and they are in danger of falling behind the curve. This week’s letter is a thought game in which we entertain the possibility of rising inflation in the US. (It will print a little longer, as there are a lot of charts!)
Quickly, Endgame is doing well, and I want to thank those of you who have read the book and given me feedback. I appreciate it. You can read the reviews at Amazon.com

 
. And now to this week’s letter.

The Curve in the Road

Back in 2002 (or so) I was writing about the curve in the road. In fact, that was the working title for Bull’s Eye Investing as I was writing it. The concept is that one cannot see around the curve in the road, so it is very important to read the signs and have good maps as you go along.
Bernanke (and Dudley) have been testifying that inflation is not an issue. But what signs and maps are they reading? Bernanke specifically invokes inflation expectations as being most important, and he contends they are low. They both note that the “output gap” (more on it later) is still high and that wage inflation is unlikely in a period of high unemployment. But, as Greenspan recently said, “The problem is, none of these indicators will tell you when inflation is about to take hold.”
The Economic Cycle Research Institute wrote what I think is a very powerful editorial about the problem with Fed policy and inflation. I will quote some of the more important paragraphs, but you can read the piece in its entirety at http://www.businesscycle.com/news/press/2137/
 
.

“By using good cyclical indicators, you can – and we do – correctly forecast when inflation is about to take hold.
“And it’s precisely because the Fed – first under Mr. Greenspan and now under Mr. Bernanke – adamantly believes that inflation turning points can’t be predicted, that the current U.S. recovery stands in danger of being snuffed out prematurely.
“ECRI’s future inflation gauges – which, unlike econometric models, monitor the evolution of self-feeding cycles in inflation – are designed to do just what Mr. Greenspan says can’t be done. Specifically, they are more direct measures of underlying inflation pressures that signal the timing of upcoming inflation cycle turning points. In fact, they also anticipate inflation expectations.
“… The Fed’s ongoing reliance on inflation expectations, along with core inflation and the output gap – which Mr. Greenspan agrees don’t work – strongly implies that they have no workable tools to decide when to pull back on stimulus. Their incoherence about policy timing is rooted in the belief expressed by Mr. Greenspan that forward-looking indicators of inflation can’t tell when inflation is about to take hold.
“Mr. Greenspan and his successor, Mr. Bernanke, are top-notch economists in an echo chamber where they are surrounded by other economists, who all tend to believe, deep down, that the best forward-looking information must be found in market prices. This is an economist’s mistake. Even in the face of compelling evidence that markets aren’t the best predictors of what’s around the bend, it’s really hard for economists to abandon their basic world-view.
“This keeps the Fed chronically behind the curve. The “insurance” taken out by the Fed has been far from costless, especially in terms of the collateral damage from unintended consequences. Yet, damaging as it might have been in the past, the sheer size of the Fed’s current balance sheet makes it more critical than ever to improve the timing of monetary policy shifts.
Central bankers need to stop clinging to policy orthodoxy and pay attention to proven cyclical leading inflation indicators that can actually tell them when inflation is about to take hold. Otherwise, if a well-meaning Fed stimulates the economy for too long, it will let inflation and/or asset prices get out of control, fostering boom-bust cycles that keep long-term unemployment at elevated readings as each short boom ends with a bust that pushes the jobless rate back up.” (emphasis mine)

Capacity Utilization Is Rising

First, let’s look at that “output gap.” The output gap, or GDP gap, is the difference between potential GDP and actual GDP, or actual output. The Congressional Budget Office makes an estimate that looks like this:

This “gap” coincides rather nicely with our old friend, Capacity Utilization. And while CU dropped to all-time lows during the last recession, it is up over 10% from the bottom, which is a much sharper recovery than during the previous recession.
The Institute for Supply Management (ISM) numbers are still good, both manufacturing and service sectors, although beginning to show some signs of price increases. Yes, there is still an “output gap,” but it is shrinking. If the chart below is any indication, that gap could be much smaller in a few years, assuming we do not experience a shock to the economy (more below).

Employment is (finally) looking better. Slowly, we are seeing initial unemployment claims come down from the record highs of a few years ago. The Fed sees the total number of unemployed and says there is no pressure on wage inflation. I think it may be more subtle than that.
Let’s look at a graph from chapter 4 of Endgame: What it shows is that employment is very skewed, as is income. This was as of the end of 2009, but the principle is the same.

The clear problem in the United States is this: If the highly skilled have 2.5 percent unemployment, how do you reduce that? You can’t. That is probably the natural frictional rate of unemployment, that is, people naturally moving between jobs or geographies. Faster economic growth or more money supply won’t bring down a 2.5 percent unemployment rate.
There are clear trends developing. Those who have attained a higher level of education are not suffering to nearly the same extent as those at the lower end of the educational scale. Indeed, conditions for certain highly skilled workers could be described as tight.
Furthermore, those who find themselves out of work are on average out of work longer now. The average time of unemployment has sharply increased from less than 20 weeks only two years ago to more than 30 weeks now—a 50 percent increase. Those unemployed for shorter lengths of time now make up much less of the total than they used to.
The majority of unemployed workers are instead primarily those in a chronic state of joblessness. Such people find it ever harder to get back into employment as their skills become rusty. This phenomenon is not confined to the United States. A similar pattern is developing in the United Kingdom and throughout the developed world. The stories of chronic unemployment in Portugal, where fewer than 30% have high school degrees, have been everywhere of late, as Portugal becomes the latest of the euro-area countries to need funding help.
There are two main types of unemployment: structural and cyclical. In this downturn we have seen fewer hours worked and lower pay; these are cyclical. More ominous, though, has been the structural decline in the civilian participation rate. There has been an extreme rise in the number of long-term unemployed, who now make up almost 3.5 percent of the labor force. Because the U.S. economy needs to shift from consumption, real estate, and finance toward manufacturing, many of the unemployed will not return to their old jobs.
“As U.S. economic growth begins to revive, the long-term jobless rate, which is still around record highs, remains a festering sore. However, it’s obvious from a scrutiny of past cyclical patterns that only a long economic expansion – like those in the 1980s and 1990s – can heal that wound.” (ECRI)
“Only a long economic expansion” is the right answer. Another recession would obviously not be good for employment.

Inflation Expectations

As noted above, the Fed pays a great deal of attention to inflation expectations and says that today such expectations are low. Let’s look at two charts (courtesy of Scott Grannis, http://scottgrannis.blogspot.com/2011/04/monetary-policy-update.html
 
) which suggest that such a benign outlook may not be in our future.



“The message of both charts is the same: inflation expectations are rising significantly. Fed supporters would be quick to note that this could just be a rational reaction to the recent and continuing rise in oil prices. But Fed critics have more ammunition: the very weak dollar, the broad-based rise in commodity prices, the all-time highs in precious metals, and the substantial rise observed to date in the producer price indices and the ISM prices paid indices. There is no shortage of evidence that monetary policy is extremely accommodative and inflation pressures are building. The last refuge of the inflation doves (the Phillips Curve theory of inflation) is being dismantled almost daily, as prices all over the world rise even as there remains plenty of slack in the U.S. economy.” (Scott Grannis)
I wrote a few weeks ago:
“And core inflation may soon be under pressure. There were two articles yesterday, one from Yahoo and the other on Bloomberg. Both related to rising pressure on rental costs. (My recent lease renewal increase was significantly above core CPI!) (From http://realestate.yahoo.com/promo/rents-could-rise-10-in-some-cities.html
 
)

“Already, rental vacancy rates have dipped below the 10% mark, where they had been lodged for most of the past three years. ‘The demand for rental housing has already started to increase,’ said Peggy Alford, president of Rent.com… By 2012, she predicts the vacancy rate will hover at a mere 5%. And with fewer units on the market, prices will explode.”
Look at this graph showing their projections:

Here’s what to pay attention to. Notice that since 2002 (or thereabouts) rental costs have been flat, and down of late (inflation-adjusted). If Rent.com projections are anywhere close, we could see a rise in rents of 15% by the end of 2012.
Let’s remember that 23% of the CPI and 40% of core CPI is Owner Equivalent Rent. If they are right, that adds about 3% to total CPI and 6% to core CPI! Will the Fed be telling us to focus on core inflation in 12-18 months? And those prices will start to show up steadily.
The Producer Price Index is rising at an annualized rate of 20%. This is starting to show up in consumer prices. Wal-Mart CEO Bill Simon recently stated that he sees “serious inflation” on the horizon, as US consumers face a sharp rise in inflation in the coming months for clothing, food, and other products. “Inflation is going to be serious. We are seeing cost increases starting to come through at a pretty rapid rate.” (Variant Perception)
The latest data we have on inflation shows that the trend is clearly up. In particular, notice the rise in the last three months since the beginning of QE2. Inflation is running at over 5% on an annualized basis. Companies like Kimberly (diapers, etc.), Colgate, P&G, and others all announced 5-7% price increases this week. These are companies that provide staples we all buy. Those prices matter. Even Wal-Mart will have to pass those increases on. To say that food and energy don’t matter misses the point. These items have real economic impact.

One last chart on inflation, and this goes back to the Future Inflation Gauge mentioned by ECRI. There is a clear correlation between the FIG and inflation, which suggests that we will soon see rising inflation.

The Transmission Mechanism

Everyone knows the Fed is going to finish this cycle of quantitative easing (QE2). But how does that translate into actual inflation?
It’s not showing up in the money supply as measured by M2. After a liquidity-induced jump during the recent crisis, M2 is growing roughly at the same rate as it has for years.

In fact, the excess money is showing up back at the Fed in the form of reserve balances with the various reserve banks.

So how is inflation showing up in commodities, oil, and food? Let me posit a few thoughts, although I am open to readers enlightening me further.
One, emerging markets are being forced to take on huge foreign reserves if they do not want to see their currencies rise. This means they are adopting the loose or easy monetary policy of the Fed, which means they are now being forced to deal with inflation. Stratfor reported today that Vietnam, for instance, has 14% inflation. China’s is in that range, notwithstanding the “official” numbers. That means they will have to allow their currencies to rise, but it also means that food and energy, which are close to 50% of their consumer spending, are very impactful. It means rising wages and higher costs, which the CEO of Wal-Mart says are now being passed on.
This easy-money policy means a lower dollar, which is another way of saying rising commodity costs, especially for oil.
And most importantly, this policy is in fact building in inflation expectations, which is most worrisome. Right now there is no fundamental reason the economy should roll back into recession in the near future. There is no need for QE3, although I have written about the potential problems when we stop the current QE2. But that being said, the US economy should be growing at almost 5% in this part of the recovery cycle, not 2.5%. This is a very weak recovery by historical standards.
What happens if there is an “exogenous” shock (something outside of the system)? What happens if there is a true sovereign debt banking crisis in Europe? That is in the realm of possibility, as I have discussed. So is another oil shock. That large weapons cache in Nigeria is worrisome. What would $150 oil do?
(Anecdotal comment. My middle son came to visit tonight on his motorcycle. “I only use the car now to go to pick up the kids at the day care. Gas is almost $4. Who can afford that? What the hell is that about, Dad?” I know some of you think I am insulated from the real world, but I see it in my childrens’ lives and those of their friends, almost every day.)
If the Fed felt compelled to “provide liquidity” through a dose of QE3, I think the markets would rebel. The dollar would certainly fall, driving up prices more, along with interest rates, if the last round is any indication.
I maintained at its outset that QE2 was bad policy, because it wasted a bullet that we might need one day. I worry about what happens if we continue to do that. Hopefully, we don’t have that shock and will have a long and sustained recovery, the government will bring the deficit down, and employment will rise. One can hope. But hope is not a strategy. We are in a hole and we seem to want to keep digging, at both the Fed and the US government. And we are exporting our problems of bad management to the world.
We have chosen deliberately to take the inflation road. We have not traveled that road for some time. The Fed may think they know what is around the curve and what to do if inflation comes back, but no two crises are the same. I worry about these things. If the Fed and the US government wanted a weaker dollar, the return of inflation, and the potential for yet another boom-bust, they could not have designed better policies than the ones they’re pursuing.

Friday, April 8, 2011

$112.50

Obama and his green tyranny must be thrilled. Their plan for costly crude is being fulfilled!

Silver Turns Forty!

Who would have ever thought one ounce of silver would be worth $40?

Beans Blast Off Following USDA Report

from Arlan Suderman tweet:

140 mln bu bean stocks replace the old 110 mln bu as pipeline bottom; It's about % of usage, which is at record tight levels
Sense that USDA is defining bottom of pipeline supplies at 675 corn & 140 beans; Simply "can't" get tighter; prices must ration

Crude Oil Just Pennies Shy of $112

(Not So) Slow Dollar Destruction

Stocks, Crude Oil Barrel Obliviously Higher

This is going to bring on another recession if it continues into the summer. There's no reason to think it won't, either! This smells just like 2008 again, and not one lesson has been learned! But with a Fed that is back-stopping risk and encouraging bubble again, and a President that is sinking us into a quagmire of debt and even more "humanitarian" wars, its not hard to see where this is going to lead. It won't be pretty.

Crude oil -- $111.65 and counting


Stocks - amazing that Bernanke and Wall Street don't perceive the bubble

Thursday, April 7, 2011

Crude Closes Above $110

$110.27, to be exact!

Another 7.4 Earthquake in Japan Sends Stocks Plunging... for 5 Minutes

Wall Street is oblivious to risk. They see the destruction of an entire country and its reversion back to Third World status as a buying opportunity.

Crude Oil, Corn, Gold, Silver Set New Records

...and cotton is limit up!

Wednesday, April 6, 2011

UN Report Reveals New Record Food Prices

(Reuters) - Global food prices measured by the U.N.'s food agency may have come off record highs in March after falls in grain prices, but supply concerns and soaring oil prices mean such a move could just be a pause before new peaks.
The United Nations' Food and Agriculture Organization (FAO) on Thursday publishes its monthly Food Price Index, which measures price changes for a basket of cereals, oilseeds, dairy, meat and sugar.
The index hit a record high in February for a second straight month, passing peaks seen in 2008 during a food crisis which sparked riots and panic buying in places as far apart as Haiti, Cameroon and Egypt.
The FAO warned last month that fresh oil price spikes and stockpiling by importers keen to avert popular unrest would rock already volatile grain markets and food prices would remain close to record highs until new crop conditions are known.
World wheat and corn prices fell in the first three weeks of March to levels well below 2008 peaks amid political turmoil in north Africa and the Middle East and natural disaster in Japan, before starting to recover at the end of March.
Benchmark U.S. wheat futures lost about 3 percent for the month of March, while corn futures fell 4 percent, but both have been rising since the start of April on the back of persistent concerns about tight supplies and bad weather.
Strong demand for grains and vegetable oils from biofuels industry is also seen by FAO and other analysts as a driving force for food price rises, despite expected increases in planted areas this year.
Soaring oil prices are also adding to food product costs.
Oil prices on Wednesday rose to their highest since August 2008, driven by unrest in the Middle East and North Africa and dollar weakness ahead of an expected European Central Bank interest rate rise on Thursday.

Corn Fuels Higher, Even With Ethanol

But Wall Street Doesn't Care, Continues March Higher

Get formula for national impoverishment!

Gold, Silver Set New All-Time Records

Crude Oil Reaches $109

This is going to kill the recovery!

Tuesday, April 5, 2011

Wall Street Oblivious to Main Street

While Crude Oil Continues Near Record Highs

What a Surprise! Gold, Silver Hit New All-Time Records!

Stocks Continue Their Rally

Choppy Charts

Risk and the Faulty Models That Increase It

“When models turn on, brains turn off.”
–Til Schulman
I have been thinking a great deal about risk over the past couple of years. The depth of the financial crisis took many of us by surprise. I made mistakes. I am sure you made mistakes. In fact, the whole industry made mistakes, from which we should all learn. Whether we will is another story, but we should try.
Making those mistakes is all the more frustrating because I was aware of the dangers but, like most others, underestimated the magnitude. In fact I wrote about them – see for example the October 2007 Absolute Return Letter (Wagging the Fat Tail).
Now, let’s distinguish between trivial risk (say, the risk of the stock market going down 5% tomorrow) and real risk - the sort of risk that can wipe you out. The geeks call it tail risk, and James Montier provided an excellent definition of it in his recent paper, The Seven Immutable Laws of Investing, where he had the following to say:
“Risk is the permanent loss of capital, never a number. In essence, and regrettably, the obsession with the quantification of risk (beta, standard deviation, VaR) has replaced a more fundamental, intuitive, and important approach to the subject. Risk clearly isn’t a number. It is a multifaceted concept, and it is foolhardy to try to reduce it to a single figure.”
Following James’ line of thinking, let me provide a timely example of the complex nature of tail risk:

The Japanese disaster

Contrary to common belief, the disaster at the Fukushima Daiichi nuclear power plant was not a direct result of the 9.0 earthquake which hit Northeastern Japan on 11 March. In fact, all 16 reactors in the earthquake zone, including the six at the Fukushima plant, shut down within two minutes of the quake, as they were designed to do. But Fukushima is a relatively old nuclear facility – also known as second generation - which requires continuous power supply to provide cooling (the newer third generation reactors are designed with a self-cooling system which doesn’t require uninterrupted power).
When the quake devastated the area around Fukushima, and the primary power supply was cut off, the diesel generators took over as planned, and the cooling continued. But then came the tsunami. Around the Fukushima plant was a protection wall designed to withstand a 5.2 metre tsunami, as the area is prone to tsunamis. However, this particular one was the mother of all tsunamis. When a 14 metre high wall of water, mud and debris hit the nuclear facility, the diesel generators were wiped out as well. But the story doesn’t end there, because Fukushima had a second line of defence – batteries which could keep the cooling running for another nine hours, supposedly enough to re-establish the power lines to the facility. However, the devastation around the area was so immense that the nine hours proved hopelessly inadequate. The rest is history, as they say.

Other tail risk events

I have included this sad tale in order to put the concept of risk into perspective. You cannot quantify a risk factor such as this one because, if you try to do so, the prevailing models will tell you that this should never happen. Take the October 1987 crash on NYSE. It was supposedly a 21.6 standard deviation (SD) event. 21.6 SD events happen once every 44*1099 years according to the mathematicians amongst my friends1(1096 is called sexdecillion, but I am not even sure if there is a name for 1099). The universe is ‘only’ about 13.7*109 years old (that is 13.7 billion years). Put differently, 19 October 1987 should quite simply never have happened. But it did. (My source is Cuno PĆ¼mpin, a retired professor of Economics at St. Gallen University.)
So did the Asian currency crisis which resulted in massive losses in October 1997, which statistically should only have happened once every 3 billion years or so. By comparison, our planet is ‘only’ about 2 billion years old. And the LTCM which created mayhem in August 1998 was apparently a once every 10 sextillion years (1021) event. And I could go on and on. The models we use to quantify risk are hopelessly inadequate to deal with tail risk for the simple reason that stock market returns do not follow the pattern assumed by the models (a normal distribution).

Black swans galore

The smart guys at Welton Investment Corporation have studied the phenomenon of tail risk in depth and kindly allowed me to re-produce the table below which sums up the challenge facing investors. In short, severe losses (defined as 20% or more) happen about 5 times more frequently than estimated by the models we (well, most of us) use.
Table 1: Severe Losses Occur More Frequently than Expected

Source: Welton Investment Corporation (www.welton.com)

Why your birthday matters

It is not only tail risk, though, which brings an element of unpredictability into the equation and effectively undermines Modern Portfolio Theory (MPT), which is the foundation of the majority of applied risk management today (more about MPT later). One of the least understood, and potentially largest, risk factors is what I usually call birthday risk. Effectively, your birthday determines your ability to retire in relative prosperity. Is that fair? No, but it is the reality. Woody Brock, our economic adviser, phrases it the following way:
“I would happily live with vast short‐term market volatility in exchange for certainty about the level of my wealth and future income at that date when I plan to retire. Wouldn’t you? Wouldn’t most people?”
And Woody goes on:
“But if this is true, then why does most contemporary “risk analysis” completely bypass this perspective and focus on shorter term risk?”
To illustrate the point, let me share with you some charts produced by Woody and his team at Strategic Economic Decisions. Most people have the vast majority of their assets tied up in property, stocks or bonds, or a combination of the three. It is also a fact that most people do most of their savings over a 15-20 year period – from their mid to late 40s until their early to mid 60s, the reason being that most of us are net spenders through our education and until the point in time when our children move away from home. It is therefore extremely important how those 3 asset classes perform over that 15-20 year period. Now, look at the charts below (all numbers are annual returns, and the asset wealth column represents a weighted average of the other 3 columns):
Chart 1a: Growth in US Asset Wealth, 1952-1965

Chart 1b: Growth in US Asset Wealth, 1966-1980

Chart 1c: Growth in US Asset Wealth, 1981-2000

Source: Strategic Economic Decisions (www.sedinc.com)
When you look at those charts, wouldn’t you just love to have retired in 2000? A solid 7.9% per year for the preceding 19 years turned $1 million in 1981 into $4.2 million in 2000, whereas those poor souls who retired in 1980 managed to turn $1 million into no more than $1.1 million during the previous 14 year period. And those who are retiring today aren’t much better off following an extremely volatile decade. This is effectively a birthday lottery but, as we shall see later, there are things you can do to address the problem.

The problems with MPT

However, before we go there, I would like to spend a moment on MPT, as I believe it is important to understand the shortcomings of the prevailing approach to investment and risk management. (Much of the following is inspired by Woody Brock.) Let’s take a closer look at three of the most important assumptions behind MPT (there are many more assumptions behind Modern Portfolio Theory. Wikipedia is a good place to start should you wish to read more about it):
1. Risk-free investments exist and every rational investor invests at least some of his savings in such assets, which pay a risk-free rate of return.
2. Returns are independently and identically-distributed random variables (returns are trendless and follow a normal distribution, in plain English).
3. Investors can establish objective and accurate forecasts of future returns by observing historical return patterns. (Strictly speaking, this assumption was relaxed by Fischer Black in 1972 when he demonstrated that MPT doesn’t require the presence of a risk-free asset; an asset with a beta of zero to the market would suffice.)
Well, if these assumptions are meant to stand the test of time, then good old Markowitz (the father of MPT) is in trouble. Truth be told, none of the three stand up to closer scrutiny. The concept of risk-free investing no longer exists, post 2008. Banks are giant hedge funds which cannot be trusted and even government bonds look dicey in today’s world. Secondly, returns are clearly not random. If you have any doubts, just look at how the trend-following managed futures funds make their money. Thirdly, from 26 years of investment experience, I can testify to the fact that historical returns provide little or no guidance as to the direction of future returns.

A new approach is required.

So what does all of this mean? First of all it means that universities and business schools all over the world should clear up their acts. Two generations of so-called financial experts have been indoctrinated to believe that MPT is how you should approach the management of investments and risk whereas, in reality, nothing could be further from the truth. It also means that investors should kick some old habits and re-think how they do their portfolio construction. Specifically, it means that (and I paraphrase Woody Brock):
i. the notion of the “market portfolio” being an appropriate performance benchmark should be discarded;
ii. there is in reality no meaningful distinction between strategic and tactical asset allocation - the difference is illusory;
iii. investors should once and for all reject the notion that there is an optimal portfolio for each investor from which he or she should only deviate “tactically” in the shorter‐run;
iv. market‐timing deserves more credit than it is given;
v. MPT is a straitjacket preventing investors from rotating between different classes of risky assets (with vastly different risk/return profiles) as market conditions change.
Please note that this does not imply that asset allocation is irrelevant. Far from it. However, it does mean that a bespoke approach to asset allocation, where individual circumstances drive portfolio construction, is likely to be superior to a more generic approach based on a strategic core and a tactical overlay.
This is nevertheless serious stuff. Effectively, Woody Brock is advocating a regime change. Throw away the generally accepted approach of two generations of investment ‘experts’ and start again, is Woody’s recommendation. As a practitioner, I certainly recognise the limitations of MPT and I agree that, in the wrong hands, it can be a dangerous tool, but there is also a discipline embedded in MPT which carries a great deal of value. And, in fairness to Woody, he does in fact agree that you can take the best from MPT and mix it with a good dose of ‘common sense’ and actually end up with a pretty robust investment methodology.

A solution to the problem

Here is what I would do in terms of applying his thinking into a modern day investment approach:
1. Do what you do best. Some investors are made for short-term trading. Others are much more suited for long-term investing (like me). Don’t be shy to utilize whatever edge you may have. MPT suggests that markets are efficient. Nothing could be further from the truth. If you have spent your entire career in the medical device industry, the chances are that you understand this industry better than most. Use it when managing your own assets. Insider trading is illegal; utilizing a life time of experience is not.
2. Take advantage of mean reversion. Mean reversion is one of the most powerful mechanisms in the world of investments. At the highest of levels, wealth has a long term ‘equilibrium’ value of about 3.5 times GDP. As recently as 2007, wealth was well above the long term equilibrium value and signalled overvaluation in many asset classes. But be careful with the timing aspect of mean reversion. The fact that an asset class is over- or undervalued relative to its long term average tells you nothing in terms of when the trend will reverse. A good rule of thumb is to buy into asset classes when they are at least a couple of standard deviations below their mean value.
3. Be cognizant of herding. We are all guilty of keeping at least one eye on other investors, and we are certainly guilty of letting it influence our own investment decisions. This is how investment trends become investment bubbles and fortunes are wiped out. Herding is relatively easy to spot despite the fact that former Fed chairman Alan Greenspan argued otherwise – probably because it was a convenient argument at the time. But herding is also subject to the greater fool theory. You can make a lot of money investing in fundamentally unsound assets, as long as you can find a greater fool to whom you can sell it at a higher price. It works fine but only to a point.
4. Think outside-the-box. All those millions of baby boomers all over the western world who will retire in the next 10-15 years have been told by the MPT-trained financial advisers that they need to lighten up on equities and fill their portfolios with bonds, because they need the income to live on in old age. STOP! Who says that bonds can’t be riskier investments than equities? When circumstances change, you should change your investment approach accordingly and not rely on historical norms. Given the state of fiscal affairs in Europe and North America, it does not seem unreasonable to suggest that circumstances have indeed changed.
5. Bring non-correlated asset classes into the frame. One should consider having a core allocation to non-correlated assets. Traditionally, many non-correlated asset classes have not met the liquidity terms required by the majority of investors (see below on liquid versus illiquid investments), but there are exceptions, the most obvious one being managed futures. The asset class proved its worth in 2008 with managed futures funds typically up in the range of 20-30% that year.
6. Take advantage of investor constraints and biases. The classic, but by no means only, example is the outsized impact a downgrade to below investment grade (i.e. a credit rating below BBB) may have on corporate bonds, as some institutional investors are not permitted to own high yield bonds and are thus forced to sell regardless of price when the downgrade takes place.
My favourite example right now is illiquid as opposed to liquid investments. I strongly believe that less liquid investments will outperform more liquid ones over the next few years for the simple reason that the less liquid ones are struggling to catch the attention of investors who, still smarting from the deep wounds inflicted in 2008­09, stay clear of anything that is not instantly liquid. This has had the effect of pushing the illiquidity premium (i.e. the extra return you can expect to earn by investing in an illiquid as opposed to a liquid instrument) to levels we haven’t seen for years.

Monday, April 4, 2011

Explanations of the Magnitude of U.S. Debt

from The Blaze:

Having trouble understanding the deficit, the budget and all the gibberish out of DC?  A friend cleared it up for me this way;

Imagine that you had an average monthly income of about $170 balanced against average monthly expenses of about $940–and that you were more than $14,000 in debt.
Then imagine that as of today, you had only $58.60 in cash left in your bank account and $130.50 left on your line of credit.
Now multiply these numbers by 1 billion and you will have the up-to-date financial situation of the U.S. government.
Any questions?

WSJ Explains How to Pull a "GE"

Wow! I wish I had known!!

from WSJ:
There's been a firestorm this week over the news that General Electric will pay no tax—at least, no federal corporate income tax—on last year's profits.

But if you're like a lot of people, your first reaction was probably: "Hmmm. How can I get that kind of deal?"
You'd be surprised. You might. And without being either a pauper or a major corporation.

I spoke to Gil Charney, principal tax researcher at H&R Block's Tax Institute, to see how a regular Joe could pull a GE. The verdict: It's more feasible than you think—especially if you're self-employed.
Let's say you set up business as a consultant or a contractor, something a lot of people have been doing these days. And, to make this a challenge on the tax front, let's say you do well and take in about $150,000 in your first year.

First off, says Mr. Charney, for 2010 you can write off up to $10,000 in start-up expenses. (In subsequent years it's only $5,000.)

Okay, let's say you claim $7,000. That takes your income down to $143,000.

You can also write off all legitimate business expenses. Mr. Charney emphasizes that this only applies to legitimate expenses.

He didn't say, but everyone seems to understand, that this can be quite a flexible term. Even if you buy a computer, a cellphone and a car primarily for business use, you can use them for personal purposes as well. If you happen to take a business trip to Florida in, say, January, no one is going to stop you from enjoying the sunshine or taking a dip in the pool.

So let's say you manage to write off another $10,000 a year in business expenses.

That brings your income, for tax purposes, down to $133,000.

You'll have to pay Medicare and Social Security taxes (just like GE). Because you're self-employed, you have to pay both sides: the employee and the employer. That will come to about $19,000.

However, you can deduct half of that, or $9,500, from your taxable income. So that brings your total down to $123,500 so far.

Now comes the creative bit. The self-employed have access to terrific tax breaks on their investment and retirement accounts. The best deal for many is going to be a self-employed 401(k), sometimes known as a Solo 401(k).

This will let you save $43,100 and write it off against your taxes. That money goes straight into a sheltered investment account, as with a regular 401(k).

Why $43,100? That's because with a Solo 401(k), you're both the employer and the employee. As the employee you get to contribute a maximum of $16,500, as with any regular 401(k). But as the employer you also get to lavish yourself with an incredibly generous company match of up to 20% of net income.

Yes, being the boss has its privileges. (And if you're 50 or over, your limit as an employee is raised from $16,500 each to $22,000.)

You can save another $10,000 by also contributing to individual retirement accounts—$5,000 for you, $5,000 for your spouse. If you use a traditional IRA, rather than a Roth, that reduces your taxable income as well. If you're 50 or over, the limit rises to $6,000 apiece.

If you contribute $43,100 to your Solo 401(k), and $10,000 to two IRAs, that brings your income for tax purposes down to just over $70,000.

We haven't stopped there either, says Mr. Charney.

Now come the usual itemized deductions. You can write off your state and local taxes. Let's say these come to $10,000.

You can write off interest on your mortgage. Call that another $10,000. That's enough to pay 5% interest on a $200,000 home loan.

That gets us down to about $50,000 And we're not done.

If you're self-employed, health insurance is probably a big headache. But the news isn't all bad. You can write off the premiums for yourself, your spouse, and your kids.

And if you use a qualifying high-deductible health insurance plan—there are a variety of rules to make sure a plan qualifies—you get another break. You can contribute $3,050 a year into a tax-sheltered Health Savings Account, or $6,150 for a family. You can write those contributions off against your taxable income. The investments grow sheltered from tax. And if you spend the money on qualifying health costs, the withdrawals are tax-free as well.

So call this $10,000 for the premiums and $6,150 for the HSA contributions. That gets your income, for tax purposes, all the way down to about $34,000.

If you have outstanding student loans, you can write off $2,500 in interest. And you can write off $4,000 of your kid's college tuition and fees.

Then there's a personal exemption: $3,650 per person. If you're married with one child, that's $10,950.

Taxable income: just under $17,000. That's on a gross take of $150,000. You'd owe less than $1,700 in federal income tax.

And it doesn't stop there. Because now you can bring in some of the tax credits. Unlike deductions, these come off your tax liability, dollar for dollar.

GE got big write-offs related to green energy. There are some for you too, although on a small scale. You can claim credits for things like installing solar panels, heat pumps or energy-efficient windows or boilers in your home. Let's say you use a home equity loan to pay for the improvements and take the maximum $1,500 write-off.

That gets your tax liability down to $200.

Can we get rid of that? Sure, says Mr. Charney.

If your spouse spends, say, $1,000 on qualifying adult-education courses or training programs, you can claim $200, or 20% of the cost, in Lifetime Learning Credits. (The maximum is $2,000.)

That wipes out the remaining liability.

Congratulations. You've pulled a GE. You owe no federal income taxes at all.

OK, it's just an illustration. Few will be quite so fortunate. On the other hand, it's not comprehensive either. There are plenty of other deductions and credits we didn't mention. You could have written off up to $3,000 by selling loss-making investments. Your spouse may be able to use a 401(k) deduction as well. There are lots of ways to tweak the numbers.

In this case, you've paid no federal income tax, and meanwhile you've saved $19,000 toward your retirement through Social Security and Medicare, and $53,000 through your 401(k) and IRAs. You've paid most of your accommodation costs (that is, the interest and property taxes on your home), covered your health-care costs and quite a lot of personal expenses through your business account, paid $4,000 toward your child's college costs and had about $2,000 a month left over for cash costs.

Who says GE has all the fun?

Eurodollar Futures Rocket Higher on ECB Rate Hike Likelihood

HONG KONG, April 4 (Reuters) - Eurodollar futures contracts expiring in March 2012 are forecasting a half point increase in U.S. interest rates, helped by increasing evidence that the economy is gaining momentum.
A widely expected rate increase by the European Central Bank on Thursday could also add pressure on the Federal Reserve to begin reversing its super-loose monetary policy.
Such an increase would be the ECB's first rate hike since October 2008 and widen interest rate differentials further between the U.S and Europe.
A surge in eurodollar futures in early March fuelled by expectations that the earthquake in Japan would stay the Fed's hand in tightening policy has taken a sharp U-turn in the past two weeks due to hawkish comments from some Fed officials.
While the disaster could push the Japanese economy back into recession for a few quarters, analysts now do not expect it to have a major impact on global economic growth.
Barclays strategists said the March employment report, which showed the U.S. jobless rate slipping to 8.8 percent, signaled a continuation of the trend towards solid business expansion, notwithstanding risks such as the Middle East unrest and rising commodity prices.
Even though the shift in rate expectations has led to some heavy profit-taking in the eurodollar and fed fund futures markets, a majority of analysts in a Reuters poll do not expect a rate hike in 2011. 
"The message here is that we do not believe the softness in the first quarter data should be interpreted as the start of a significant slowdown," they said.
Underlining that optimistic view, hawkish comments from some Fed officials hurt the market last week with two-year Treasuries , seen as among the most vulnerable to interest rate risk, underperforming longer-dated debt including 10-year notes.
Two-year notes briefly tested support at yields of around 0.89 percent on Friday, their highest levels since last May before subsiding to around 0.80 percent on Monday.
The gap between two-year and 10-year note yields has narrrowed to around 266 basis points from 283 bps on March 8.
Players in the fed fund futures markets are expecting about 40 bps of increase in U.S rates by March 2012.
Rate markets are also eyeing a speech by Fed chief Ben Bernanke later in the day where he might temper some of the recent hawkish comments by other Fed officials. (Editing by Kim Coghill)

Chris Martenson Discusses the End of QE2

from Chris Martenson:

The Fed is in a bind.  No matter which way it turns, utter failure is a risk.  Putting more money into the system risks no less than the dollar itself.  Stopping quantitative easing (QE) risks plunging the economy and financial system into another period of turbulent decline.  It looks like they are going to choose the latter.
In a recent report, I made the case that pressure was building on the Fed to end its QE 2 program in June, and that if it did, there would be an enormous rout in the stock, bond, and commodity markets. That analysis still stands.
This new two-part report will analyze the many competing factors, both for and against, that will determine whether QE 2 really is the end of the Fed's efforts at printing up a recovery, or merely the event that precedes QE 3. The factors are numerous and polarized. On the one hand there are many signs of economic recovery - the very best that a few trillion can buy - and on the other hand there's $108/barrel oil and a deeply uncertain future for Japan over the next 3-12 months.

Fed Adopting Tougher Posture

Recently the Fed has trotted out several of its governors to make the case that they are serious about ending QE 2. Strangely, they chose Friday and Saturday to go on a publicity tour -- days of the week normally reserved for news that is being buried, not exposed.
I found the following news snippets odd, not just because of their Friday/Saturday timing, but because they are all versions of the story purporting that the Fed is "thinking about tightening."
Fed’s Fisher Says He Backs Ending Central Bank’s Jobs Mandate
March 25, 2011, 2:45 PM EDT By Vivien Lou Chen and Jennifer Ryan March 25 (Bloomberg) -- Federal Reserve Bank of Dallas President Richard W. Fisher said he supports the idea of dropping the central bank’s congressional mandate for achieving full employment.
Fed's Plosser: Funds rate should hit 2.5% in year
March 25, 2011, 12:38 p.m. EDT By Greg Robb WASHINGTON (MarketWatch) - The Federal Reserve should hike interest rates from current range near zero to 2.5% within a year under a plan unveiled Friday by Charles Plosser, the president of the Philadelphia Federal Reserve Bank. Plosser did not give a specific time when this exit would begin but said it would have to start in the "not-too-distant future." In a speech to economists from the monetarist school on Friday, Plosser laid out an aggressive plan where the Fed would sell $125 billion of assets for each 25 basis point increase in the funds rate.
Fed Policy Makers Should Review QE2 Strategy, Bullard Says
March 26, 2011, 9:00 AM EDT By Scott Hamilton March 26 (Bloomberg) -- U.S. Federal Reserve policy makers should review whether to complete a second round of quantitative-easing purchasing due to end in June because of strong U.S. economic data, Federal Reserve Bank of St. Louis President James Bullard said.
All of these are part of a carefully choreographed PR campaign by the Fed to signal to the market that it is serious about ending QE efforts.
A week later, in another Saturday release (April 2, 2011), Bill Dudley offered up perhaps the clearest view of what the Fed is thinking:
Faster-than-expected payroll growth last month shouldn’t alter the U.S. central bank’s plans to buy $600 billion in Treasuries through June to prop up the recovery, said William C. Dudley, president of the Federal Reserve Bank of New York.
“I don’t see any reason to pull back from that yet,” Dudley said to reporters after a speech yesterday in San Juan, Puerto Rico. Market expectations are for the Fed to complete its planned bond purchases in June and not to announce additional buying, he said. “I don’t view those expectations as unreasonable in any significant way.”
(Source)
So the messages given a week earlier were digested by the markets, and the Fed decided to sharpen things up a bit by saying that the $600 billion program would be completed, but that's it.  It seems clear they want us to prepare ourselves for a sudden termination of QE at the end of June.
To further drive the point home, the Fed recently conducted a couple of "reverse QE" transactions, a.k.a. 'tri-party reverse repos,' which are nothing more than the Fed doing the exact opposite of QE -- putting Treasury bonds out and taking cash back in.
The scope of these operations was quite small, $1.75 billion in one instance and $0.75 billion in the other. But their true importance lies in their signal to the market that the Fed may someday not only stop the QE program, but reverse it.
Altogether, the Fed is sending out very strong signals that it intends to at least halt QE2 on schedule and not immediately move to QE3. There will be a pause.

What happens if the Fed abandons QE?

The reason we should all be quite concerned about the Fed ending its QE efforts is that the asset markets will take quite a dive if it does, but each for their own reasons.
Let's be clear about what the Fed has been doing with its QE programs: it has been printing up high-powered money out of thin air and exchanging it for Treasury notes (and bills and bonds). This shows up beautifully in the monetary base charts dutifully kept over at the St. Louis Fed:

(Source)
The monetary base has gone up by some 300% since the start of the crisis. This is the money that has been sneaking out into the commodity, stock, and bond markets.
We can appreciate the scale of this in the amounts that are now being funneled into the capital markets on a near-daily basis:

(Source)
What we need to consider is what will happen when an average of $4.4 billion dollars per business day are no longer flooding into the markets. Will asset prices be at risk of falling without these massive daily infusions of liquidity? You bet.
And add to this an unexpected threat that's just entered the picture: Japan.

A Disturbance In The Force

The biggest risk here, aside from parts shortages and supply chain difficulties, is what happens when the flood of liquidity that has emanated from Japan over the past two decades reverses course and flows in the other direction. This is a major transition (which I expounded upon more deeply in a recent post for my enrolled members) for which both Japan and the world economy at large are wholly unprepared.
If we add the idea of the Fed terminating QE, which has been enormously supportive of Treasury prices (and therefore low interest rates) to the idea of Japan suddenly becoming a net importer of funds instead of an exporter, we can quickly arrive at the risk of a rather unpleasant period for US Treasuries -- and, by extension, many other government bonds.
Already the governments of Portugal, Greece, and Ireland are paying rates on their sovereign bonds that are way above their nominal rates of GDP growth, which is a certain recipe for financial disaster. It's as if to survive, you need to borrow by using your credit card, even though your rate of interest on the card is several times larger than your yearly salary increases. Eventually that ends badly, and everyone knows it.
Along with that, we have to consider the idea that rapidly rising interest rates in the US Treasury market are destabilizing in other ways, but especially to the $600 trillion dollar derivative market - a significant portion of which is tied to US Treasury interest rates. Who knows what sorts of accidents await in a market that is too complicated to grasp in its entirety?
Of course, the US housing market, still struggling from poor sales, a massive shadow inventory, falling prices, and far too much negative equity, will perform especially poorly if interest rates rise.
If the Fed terminates QE on schedule, then I think a tsunami metaphor is apt. First, all of the liquidity will drain out of the bay, leaving countries, governments, and institutions to flop about in the mud. Then the Fed will panic and resume the liquidity flood, feeding the wave that will rush back in to destroy the lives and portfolios of those who positioned their wealth in harm's way.
The biggest problem with the current situation is that there's practically nowhere to hide. To an unprecedented degree, all of the world's markets and all assets classes are now trading in synchrony. If all of the assets in all the world's markets are moving up and down together, where does one go to sidestep the policy foibles of the Fed?
In Part II of this report, Finding Shelter From the Storm, we delve into specific strategies to consider for preserving wealth during these very turbulent times - as well as offer trading guidance for those willing to put risk capital into play. We explore what is likely to happen to the major asset classes (stocks, bonds, precious metals, housing, commodities) as the Fed attempts to tighten, and what is then likely to transpire if it later throws in the towel and begins printing again.
There are treacherous waters ahead. Liquidity will leave of the system and then come crashing back in. The unwary will lose nearly everything in the process, and so will some of the wary. Beating this current period of financial disruption by preserving your wealth will not be an easy task. Those looking to do so should consider reading Part II of this report  (free executive summary; paid enrollment required to access).