What to Expect from Expectations Management

The Fed Chairman has become a fan of his abilities to manage wall streets' expectations. We do not believe its that easy and he has to be looking further down the road than he may be.  One mantra, which Wall Street has grasped on to, largely because its self satisfying, is that QE2 will result in consumers getting nervous about future inflation and therefore spend more now.  That strikes us as way too simple.  It's like exposing a bishop in chess so that the other player, in their greed, will take take the bishop and expose their queen to you. Maybe, but if you are only thinking one move ahead, and focus mostly on the outcome you want to see, rather than all that could occur, you will be surprised, and not in a good way.

What if QE2, rather than spurring consumer activity, actually has the opposite affect?  For every person out there in a rush to spend their money, especially if prices are going up, there has to be someone who is watching TV, reading the paper, or listening to the radio who is getting concerned about the future. Are taxes going to be much higher in a few years? In 10 years? Will benefits that you take for granted now, be extremely reduced or taken away all together? More people have to be getting worried about the long term consequences of reduced spending or increased taxes and that may encourage greater savings now, rather than less, even though for most of us, long term future is next Saturday.  Likely we will see great shopping numbers this weekend, but I think the theory that inflation expectations will increase consumption will be put to the test over the next few quarters, and will fail.

Another area where expectations seemed to have shifted, is the attitude of sovereigns in Europe. It seems that early on in the Greek crisis, the consensus view was that evil Wall Street was cutting off financing, and that the problems were one of short term liquidity and nasty hedge funds.  It seems that Europe, and Germany and Austria in particular are starting to realize that the problems are structural and likely won't go away. Its not just a matter of shifting out the maturity time-line, its the realization that they should expect losses on their bail-outs! Doesn't it make a lot more sense for them to force the pain onto existing holders and deal with the problems, which will be large, from a position of strength, rather than taking on the problems and taking on the real risk of loss in the future, and that their own economies won't be as strong then as they are now? We would be careful playing the sovereign bail-out game as expectations of real potential losses grow. We would also read the analysis we put out on EFSF and the domino effect that drawdowns create. We have no clue what to make of the Korea situation. Our gut tells us it goes away without amounting to much, or even if it grows, the market will deal with that. It would be very interesting to find out that food shortages in the North have anything to do with the activity - if you can't have bread and circuses for the masses, might as well at least have the circuses.