The theme was once again quantitative easing today, but those euphemisms are now giving way, it seems, to a more direct and honest approach that will see the Fed directly targeting inflation expectations, probably through TIPS rates. We will quote pieces from a crucial passage from yesterday's release of the FOMC minutes, and then will try to explain some of the reasons that led the markets to react so wildly to the Fed's statements.

"Many participants noted that if economic growth remained too slow to make satisfactory progress toward reducing the unemployment rate or if inflation continued to come in below levels consistent with the FOMC's dual mandate, it would be appropriate to provide additional monetary policy accommodation...Meeting participants discussed several possible approaches to providing additional accommodation but focused primarily on further purchases of longer-term Treasury securities and on possible steps to affect inflation expectations... A number of participants commented on the important role of inflation expectations for monetary policy: With short-term nominal interest rates constrained by the zero bound, a decline in short-term inflation expectations increases short-term real interest rates (that is, the difference between nominal interest rates and expected inflation), thereby damping aggregate demand. Conversely, in such circumstances, an increase in inflation expectations lowers short-term real interest rates, stimulating the economy. Participants noted a number of possible strategies for affecting short-term inflation expectations, including providing more detailed information about the rates of inflation the Committee considered consistent with its dual mandate, targeting a path for the price level rather than the rate of inflation, and targeting a path for the level of nominal GDP. As a general matter, participants felt that any needed policy accommodation would be most effective if enacted within a framework that was clearly communicated to the public. The minutes of FOMC meetings were seen as an important channel for communicating participants' views about monetary policy. "

If the reader recalls the debate about the theoretical optimum for interest rates as indicated by the Taylor Rule, which has been a negative number for quite a while, and the obvious difficulties of actually implementing such a subzero rate policy, the comments about "a decline in short-term inflation expectations increasing short-term real interest rates" achieves an immense significance. What the Fed is trying to tell us is that, since they cannot lower nominal interest rates any further (they are already at zero), they will instead lower real interest rates by increasing inflation, and widening the gap between the nominal zero rate and the CPI rate, which will of course be a negative number. Crucially, it has no bottom, since the only bottom that can be imposed on it is the CPI value that has no upside limit beyond what the Fed determines for it. This is exactly what the Fed plans to do in order to combat the scenario where "a decline in short-term inflation expectations increases short-term real interest rates". To put it shortly, the Fed is trying to lower interest rates deep into the nagative territory by indirectly manipulating them through the CPI value. Given the enormous size of the U.S. economy and the size of the markets dominated by the USD, this will sooner or later involve the injection of enormous quantities of the American currency into the FX market through the various securities markets, and any other channels that the Fed deems appropriate. Hence the huge bear trend in the USD.

As far as we are concerned, this is a momentous statement coming from the Fed and it should be noted on the calendar as cornerstone in the development of the present downturn stretching all the way back to August 2007. Up till now, all the remedial measures adopted by various governments had been focused on maintaining an ad-hoc approach, plugging holes, and patching up bankruptcies as they arise, while turning a blind eye to the severe damage that this approach was wreaking on sentiment. It was expected that people would be willing to go on with business as usual even as they saw edifices of wealth and power sinking into the earth all around them, and as they observed relatives and neighbors being forced to deal with joblessness and poverty. That is not the case, as we watch the U.S. savings rate rising rapidly, and hands finding the wallet with far greater hesitancy than before. The Fed is obviously regarding this as a warning sign of deflation, and with this broad and sweeping measure it seeks to address the issue at its core, but whether it will find a response or not is open to debate. We are convinced that the new measures will inflate assets further for a while, but we are highly pessimistic that the anticipated revival of demand will take place.

After all, there is a little bit of a paradox in the statement of the FOMC where the proposed remedy to consumers being too cautious about prices is letting those prices increase faster, in the expectation that they will have to rush to the stores in order to purchase the needed goods before they become too expensive. But we fail to see how the best way of invigorating a consumer worried about price rises and costs is forcing them to suffer even more of the same. FOMC minutes and anecdotal evidence confirm that buyers spend a lot of time trying to find the most suitable goods at the cheapest prices. It is equally possible that instead of running to the stores to pick up as many goods as possible before prices go higher, consumers will simply be satisfied with lower standards of living, smaller volume of purchases, and will just get used to their new normal. It is too early to say which of these two will be the case, but in light of the Japanese experience, we would be inclined to think that the probability of the latter is much greater than the former.

Geithner voices optimism on China, Zhou

Recent comments by Treasury Secretary Timothy Geithner appear to strike a balance between pressuring and encouraging China to do more of the same. He was calling for "gradual, but a significant pace" of appreciation for the Yuan, at the same time implying that the appreciation trend of the past six weeks, where the Yuan rose by about 2.5% against the USD has been encouraging. The same gently goading approach seems to be maintained in Washington for now, but the true test of the success of all the pressure so far brought upon the Chinese will only be evident after the November elections.

Today's dollar sales were in part inspired by the huge jump in Chinese FX reserves, illustrating once again the huge difficulties that the Chinese face as they try to unwound their self-made monster. The FX reserves of the nation rose by some $194 billion to $2.64 trillion dollars, even as the trade balance came weaker than expected at $16.9 billion, continuing the deceleration trend in place since August. The rise in reserves is almost certainly created by speculative inflows on the back of appreciation expectations. Interestingly, enough, the PBOC head, Zhou Xiaoquan made some abrupt, and unelaborated statement today that the PBOC won't raise rates until end of this year, which we take as a rather timid and futile effort to curb the appetite for speculative inflows, even as the Yuan, continues its one-way appreciation path, flushing the country with uncontrollable and unwanted amounts of new liquidity every day. If China raises interest rates to suppress economic activity, speculative flows will get even more rampant, completely neutralizing the effect of rate policy. China is doomed by protectionism if it doesn't appreciate, and doomed by bubbles and possible economic collapse if it does. We certainly don't want to be in their place at the moment.

Meanwhile in the rest of Asia, after imposing that massive new layer of taxation on foreign inflows into the fixed income market, Thai authorities seem to be pleased with how they are doing. Today, they and the Japanese were repeating their statements about their readiness to take further measures in case that "volatility returns". But reports about the liquidation of large volumes of options hedges against yen rise today seem to suggest that the market has shifted to the wait-and-see mode with respect to these currencies until the G-20 meeting late this month, and the November FOMC decision. Though, of course, we are not so sure on this particular point.

QE2 expectations see sovereign credit sentiment ease further, Euribor and Euro Libor rates rise

The expectation that we will soon be awash with cash has been contributing a great deal to the improving sentiment about the periphery, and today was not an exception. Spreads in the bond market, and CDS are on the stronger side today, with Greece leading the way and tightening down its 10-year spread from more than 950 in early September to around 660 bps at one point during the day.Ireland also saw improvement, but not by as much. The uptrend in the interbank market has been ongoing. 3-month Euribor rose from 0.982% to 0.985%, while Libors rose by a small amount as well. In spite of the markets bullishness we are not at all moved from our basic bearish outlook on the Eurozone, since the huge issues that have been put to sleep mode nowadays will have to be resolved at some point, which will cost the value and the credibility of currency a good deal one way or the another.

It is a rather interesting week with strikes in Europe, global interventions, currency wars, a race to higher taxation of capital being disregarded in the euphoria of the markets over QE2. Yet for once it is not fair to blame the market, since the Fed was clearly and unequivocally aiming for exactly such a euphoric mood when it made the minutes public. They have established a destructive symbiotic relationship with the markets, where each side feeds parasitically on the expectations of the other, and we suspect that neither will agree to be weaned except in the face of overwhelming force. The lot of traders is exploiting this situation in the most profitable manner that they can...