The First Signs of Reversal???

Early in his testimony this morning, Fed Chairman Ben Bernanke said that a premature withdrawal of QE might put the economic recovery at risk. However, by late this morning, Bernanke came ever so close to giving us the first indication of a policy reversal. According to the Wall Street Journal, Bernanke said that the Fed “could begin winding down its $85 billion-a-month bond-buying program at one of its “next few meetings” if the economic data continues to improve.” In the same breath, however, the authors go on to say that Bernanke “warned market participants that a step down in purchases won’t mean the Fed has started a one-way march toward the exit.” At the end of the day, the only bankable info we seemed to get was that the course of future policy will be dependent upon “real and sustainable” improvement in the labor market. Really not much change, if you ask me.

But the markets appear to have interpreted a change of course. The market action today suggests that today’s events may prove to be the first in a long series of steps toward policy reversal. As I write, the Dow Jones Industrial Average is off its highs of the day by nearly 250 points. We also saw heavy selling of Treasury bonds starting at about 10 am. The yield on the 10-year Treasury now sits at 2.03% compared to about 1.93% at yesterday’s close. The price of gold also reversed course today after spiking above $1,400 per ounce this morning. The current price is about 3.5% off the highs of the day. Each of these trading developments is telling us the same thing. Investors fear that we are getting incrementally closer to the beginning of the end of QE.

Bernanke is performing a tightrope act. The wide market swings at just the hint of policy change offer proof of the difficult course ahead. Bernanke is trying to produce a goldilocks recovery in the employment market while ensuring that inflation does not rise to unacceptable levels. Included in his assessment of inflation is the level of asset prices (stocks, bonds, real estate, etc). In response to a question by a member of Congress, Bernanke conceded that his concerns about financial stability (ie, asset bubbles) have increased a little bit recently. However, he also said, “Our sense is that major asset prices like stock prices and corporate bond prices are not inconsistent with the fundamentals.” He went on to say that P/E ratios are not out of the range of historical averages. (Importantly, he did not mention that corporate profit margins, which determine the denominator in the P/E ratio, are well above historical averages. But let’s not worry about that for now.)

Our fear is that Bernanke will not soon reach the level of confidence he desires in a “real and sustainable” improvement in the labor market. Each time he becomes comfortable enough to start taking his foot off the gas, markets will swoon and the Fed will come racing back with more asset purchases. Why? Because the economy is simply not able to stand on its own two feet yet. There are a number of reasons for this. The first and most obvious is that tight fiscal policy is offsetting much of the benefits of loose monetary policy. Second, we have to remember that we are recovering from the worst recession since the Great Depression, and that this recession involved a debt crisis. History tells us that the deleveraging associated with these types of recoveries takes much longer than a recovery from a more moderate, garden-variety recession. And finally, Congress seems completely unwilling to address the long-term structural deficits created by Social Security and Medicare. A successful resolution of the entitlements problem would give Congress more flexibility with near-term fiscal policy.

Our overriding concern is that one small institution, the Federal Reserve, seems intent on determining the appropriate level for stock prices. Frankly, we believe the Fed has overstepped its powers. Bernanke may very well be right that stock prices remain reasonable at today’s levels, but why does he get to decide? Is it reasonable to believe that he will make a determination, say 10% or 20% from now, that stock prices have gotten too high? These are the questions that keep me up.

Remain invested but defensive. Rough seas may be ahead.