Is the UK Providing A Blueprint for a post “QE” World?

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As we approach the jobs report later in the week, we need to be mindful that the greatest risk from an economic data standpoint isn’t of weakness, but instead inordinate strength, which could then sow the seeds of the market doubting “ZIRP.”  It wouldn’t mean that stocks would sell off immediately, but as we look out over the coming weeks and months, the risk of the market losing confidence in ZIRP is the biggest threat to the stock market, and the better the economy gets, the higher the chances.

Luckily, though, we have a bit of a leading indicator for what might happen if and when the market does begin to lose confidence in the Fed’s ZIRP.  The UK is somewhat of a “blueprint” for what we can expect here in the US, now that the Fed has started tapering QE and is relying more on “Forward Guidance” as a policy tool.  The UK shifted its policies away from QE to “Forward Guidance” over the past year, and that has resulted in higher stock prices as the economy improves, higher bond yields and a stronger Pound (sound familiar?).

But, given the economic improvement in the UK, the bond market is starting to challenge the BOE’s “forward guidance,” and if growth continues to accelerate, we will likely see the bond market begin to “revolt” against the BOE before we see something similar happen here.  It isn’t happening yet, but they have a head start on us, and it will be important to watch how risk assets in the UK react if and when the market begins to lose faith in the Bank of England’s “Forward guidance.”  It shouldn’t happen any time soon (meaning the next few months), but the UK remains a leading indicator, of sorts, for the US.

The pressing issues in bonds remain 1) When and by how much will the Fed taper QE again, and 2) If economic growth accelerates, how long before the market calls “BS” on the Fed’s “forward guidance.” For now, the indicators of whether this sell off in bonds is “ok” for other risk assets continued to behave last week as EMB and PCY (emerging market bond ETFs) saw small rallies while the emerging market ETF CEW dropped by 1%, but that was because of declines in the Thai Bhat and Turkish Lira (both countries are seeing political instability – it’s not reflective of broader emerging market weakness.

As I see it, though, the likely outcomes of both issues result in lower bond prices and higher yields, and it’s just a question of when the next leg down starts, and how fast the drop is.  If economic data suddenly turns for the worse that will change, but for now bonds are just biding their time before the resumption of the declines.  And dips in TBT, TBF and STPP should be viewed as opportunities as this trend has a lot longer to run.

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