The markets have been rallying over the last month due not to expectations of a recovering economy but "hope", yet unfulfilled, of further balance sheet expansion programs from the Fed and the ECB.  While each Central Bank meeting and EU Summit has come and gone with "no action" - market participants have ramped up the "risk on" trade expecting action at the next meeting.  During this time, as the markets salivate in anticipation of the next round of "globally injected goodness," the bullish arguments for the market and the economy have continued grow.

Goldman Sachs - Jan Hatzius

"Developments over the past few weeks have reinforced our view that US growth will improve modestly. First, the temporary negatives—the inventory cycle, the weather unwind, and the potential seasonal adjustment distortions—are now clearly behind us. Second, the housing recovery is picking up steam, with a sharp increase in the NAHB homebuilders index (the best short-term leading indicator of housing activity) and ongoing improvement in house prices. Third, real disposable income has continued to recover and is now up 4% on a 6-month annualized basis; this pace is unlikely to be sustained as the stabilization in oil prices feeds through into retail energy prices, but the gains do provide a basis for somewhat better consumer spending. And fourth, financial conditions as measured by our GSFCI have reversed all of the tightening that took place in the spring and now stands at the easiest level since August 2011."

Pragmatic Capitalist - Employment Better

The US labor market is better than most think and no signs of imminent collapse.  Friday's job's report was a big surprise to markets. But if you've been following one leading indicator of the US labor market then severe deterioration wasn't expected. The temporary help index has tended to lead the economy as companies tend to shed temporary workers before firing full-time workers (and vice versa coming out of recession). The latest readings on temp help showed a continued expansion. It's certainly not an infallible indicator, but thus far it's been a prescient indicator of the labor market. And the latest readings are consistent with a labor market that remains stable (though obviously not booming).

CitiGroup Economic Surprise Index

"The Citigroup Economic Surprise Index has proven relatively prescient over the course of the last few years. The index is intuitive in that it compares analyst expectations to actual readings.  The index tends to show when market participants are caught leaning too far in either direction. The latest readings show an analyst community that remains pessimistic, but is turning increasingly less pessimistic. This could mean we're in for more data that surprises to the upside."

Yields Falling In Spain and Italy

In order for the ECB to bailout Spain - Spain must formally request a bailout.  However, if Spain requests a bailout, with the attached austerity conditions, it will likely mean the end of the careers of the current politicians.  However, with borrowing costs dropping dramatically since the famous Draghi "Do Anything" speech there is very little incentive for the Spanish government to request a bailout at this time.

The same goes for Italy.  Mario Monti must also request assistance in order to activate the EFSF facility.  However, with borrowing costs subsiding and no real desire to become ultimately under the control of the German Bundesbank, there is no pressure for Monti to request assistance now.

So, for the career politicians, instead of having to ask for aid which would tie them into tough oversight measures - the market's response in anticipation of forthcoming aid has now precluded such requests - at least for now.

The question then becomes what happens when the cycle once again repeats with yields spiking and no funding mechanism yet in place?  Will "talk" once again do the trick or will the markets demand "action?"  

Asset Prices Doing Well

When Bernanke launched QE 2 in 2010 he stated at that time that increases in asset prices should lead to increases in consumer confidence and stronger economic growth.  At that time the markets were down 14% from their peak and 8% for the year.  In 2011, as"Operation Twist" was implemented the markets were down 19% from their peak and 10% for the year.

Today, with the markets near the highs of the year, and up more than 10% year to date, there is little need to boost asset prices further with a program that will also increase inflationary concerns.  As we have discussed previously, if the Fed is going to use a "bazooka" they want to make sure that they will have the maximum effect possible.  With the markets currently pricing in a large portion of any effect a future QE program might have there is little impetus to push the Fed forward.  

Talk Is "Cheap"

So while the markets rally trying to get in front of a further Quantitative Easing program by the Fed and the ECB - they have, by their own actions, eliminated the need for Spain or Italy to ask for bailout from the ECB and for the Fed to launch a further round of easing.  If Goldman and Citigroup are correct then the economy is about to start showing more recovery.  This means that the Fed, and the ECB, have achieved the "nirvana" of market stimulus - by lowering yields and increasing asset prices through "talk" which is much cheaper than taking action. 

The good news is that this gives the ECB the precious time necessary to arrive at some sort of agreement with Germany to put the ESM into place as a bailout tool and resolve the impasse that currently exists between Germany and the rest of the Eurozone.  Whether the Eurozone can be saved is still up in the air, however, being able to buy time with"talk" rather than"action" leaves some bullets for future when a more systemic risk is present.  Unfortunately, a more systemic type event is really only a function of time. 

For the Fed the run up in asset prices, combined with an economy that is not entirely falling off the cliff, allows them to be much more selective about what monetary tools and policies to use and when.  More importantly, it allows them to stay out of the potential fray of being seen influencing the upcoming election.  

Furthermore, with the markets doing the bulk of the work for the Fed this give Bernanke the opportunity to save his ammunition to potentially work in conjunction with the next Administration to combine both fiscal and monetary actions to stimulate a stronger economic recovery.  Bernanke has been explicit that the Fed's tools are extremely limited and that Congress must act.  However, it is extremely unlikely that Congress will do anything until after November leaving Bernanke working in a vacuum in the meantime.  Therefore, it is highly likely that the Fed will not take action before the end of the year at the earliest.

The"irony" is that the markets, by rushing to take on risk in anticipation of the"risk on" trade created by further stimulative programs from the Fed, have effectively eliminated the need for the very thing they are craving.  This does substantially increase the risk profile of the markets in the future to disappointment either from the data itself or from inaction by the Central Banks in the near term.