By: Costas Bocelli — August 25, 2011
Let’s face it: lately it’s been pretty hard trying to stay on firm footing. In fact, my new favorite evening cocktail has been a martini, shaken not stirred.
The equity markets have been on an epic roller coaster ride, with nauseating daily moves in excess of 3% during the entire month.
In the commodities space, Gold has rallied nearly $400 an ounce during this same time span, only to give back $150 in the last two days!
And to top it off, the very ground that I walk on even began shaking as the Atlantic Seaboard of the U.S. (where I reside) experienced surreal vibrations from a rare 5.9 magnitude earthquake this past Tuesday.
It only seems befitting that Ben Bernanke will be giving his widely anticipated key note address at the Central Bankers Symposium in Jackson Hole, Wy. tomorrow morning.
The big questions: how will the markets react to his remarks, and do we need to strap on a hard hat for yet another most likely volatile day of trading?
Equity markets have been addicted to unconventional monetary stimulus since the market bottomed in early 2009 as the Fed embarked on its first round of quantitative easing in late 2008, buying up over $1.7 trillion in mortgage backed securities.
At last year’s symposium, Bernanke set the stage for a second round of quantitative easing, which put a floor under the equities market the week of the speech and ignited a monster rally. The Fed made it official in November and began an eight month, 600 billion dollar spending spree buying up U.S. Treasuries.
Ironically, the program ended this past June, which closely coincided with the highs in the market. Now, with the markets correcting and many of the same problems plaguing the economy and posing a serious threat to a recession or stagnant growth, will Bernanke make any inference in his speech alluding that more monetary stimulus is on the way?
More Stimulus or Market Disappointment?
No doubt the Fed Chairman is under a great deal of pressure (not to mention heavy criticism) over the implementation of quantitative easing.
The Fed balance sheet now stands at $2.9 trillion and holding steady, as the current level is being maintained through additional bond purchases to counteract the attrition of maturing securities in the portfolio.
While the previous two rounds of QE have had a profound effect and served their purpose, engaging in a third round may prove much more difficult for Bernanke.
In the last FOMC policy statement on August 9, the Fed elected to alter its language and set a time expectation on how long “for an extended period” means in regards to interest rate policy. By stating that rates shall remain low until mid 2013, it had a profound effect on the yield curve and overall interest rates.
That simple, transparent statement virtually turned the two-year Treasury note into overnight paper yielding 0.18%, and drove the 10 year note yield down to 2.00%. And this was accomplished without any additional increases to the balance sheet.
While the balance sheet did not increase, this is definitely a monetary stimulus ploy, and for the first time in almost twenty years, three voting members on the committee dissented in the statement. This is a clear signal that launching additional asset purchases will be far tougher.
Also, the political backlash and negative rhetoric has been harsh, and implementing any additional QE that raises the size of the balance sheet will further agitate the political debate.
Many Republican Presidential candidates vying for the White House in 2012 have voiced their displeasure over recent monetary policy. Front-runner Mitt Romney strongly opposes any more monetary stimulus to boost the economy. Texas Governor Rick Perry went as far as to say that he would consider it “treasonous” if Fed Chairman Ben Bernanke “prints more money between now and the election.”
Now, I believe that Governor Perry was being a bit melodramatic in his remarks, and I don’t think he would pursue charges of treason against Bernanke if he goes the QE3 route, but the point here is that there is indeed a strong political opposition to implementing further measures right now, especially since the last round of easing did little for boosting employment or housing prices.
Another difficult hurdle that may stand in the way of QE3 has to do with very important economic data that directly involves the Fed’s most important mandate: price stability.
When QE2 was launched last year, the Fed’s primary thesis for the program was to deflect a threat of deflation and falling prices. And while prices were indeed declining, primarily on the core level (stripping out food and energy), the bond buying program seemed very justified.
But since they injected the $600 billion into the system, prices are now running hot on headline inflation, and even core inflation is approaching their target levels of 1.7 to 2.0%. This is going to make it very tough if they choose to inflate the balance sheet further (QE3).
So What Will Bernanke Say?
His speech will most likely rehash the current state of the economy that was outlined in the prior FOMC statement and his latest testimony in front of Congress.
He will also outline other monetary tools that could aid the economy, which we’ve heard before. He will talk about the possibility of reducing the interest rates they pay banks on money held in reserve. He will talk about reinvesting the runoff maturing securities into longer dated treasuries to further flatten long term rates.
And, in regards to a potential QE3, he will most likely reiterate that the committee will continue to review the size and composition of the balance sheet and make appropriate adjustments as needed. That statement does leave the door open for a QE3, but the market may want it now or it could be disappointed.
While a QE3 may be a possibility, the Fed will most likely save that bullet for any further deterioration in the markets or clear signs the economy is heading into recession.
So again, the big open question heading into Bernanke's speech:
Has the market come to grips to the fact that Bernanke will most likely need to stand pat on QE3 for now, or will we see a massive sell-off if he "disappoints"? Or, will he invoke his “helicopter” moniker and telegraph another large scale asset purchase program, igniting a monster rally?
Either way, tomorrow will be a very big day, and I welcome you to post your opinion on what the Fed Chairman should say, and how you think the market will react once his statements begin hitting the tape.