Markets Have Trapped Fed On QE3
The markets, as expected, were disappointed by Bernanke this morning during his annual "Humphrey Hawkins" testimony as he gave no indication of further rounds of Quantitative Easing. With the failure of Pavlov to ring the "bell" - the immediate response was to begin selling the market. However, it only took moments before Senator Chuck Schumer salvaged the market's hopes as he stated in response to Bernanke's testimony: "Given the political realities, particularly in this election year, I’m afraid the Fed’s the only game in town. I would urge you to take whatever actions you think would be most helpful in supporting a stronger economic recovery.“
That statement was directed at Bernanke's argument, which has been repeated at each FOMC meeting since last September, that the Fed's policy tools are quite limited and that Congress must act with fiscal policy measures to promote economic growth. The obvious problem is, that under current conditions, fiscal stimulus is unlikely as Schumer stated: "The bottom line is very simple, we’re not going to get the fiscal relief we want at least over the next short while. Perhaps after November we will. Mr. Chairman, get to work." With that the markets reversed course and moved higher as traders did not want to be caught underweight equities "when" Bernanke begins to stimulate the market.
However, Bernanke has been quite clear in past testimony, as well again today that stimulative programs have had a diminishing rate of return on both the markets and the economy. He repeated today in response to Schumer that: "The complication, of course, is we are dealing with less conventional tools and we have to make assessments about their efficacy and the costs and risks may be associated with them." While market participants were busy buying into the market on the back of Schumer's statement - they overlooked this very key statement from Bernanke.
The chart shows the problem that the Fed faces with liquidity driven programs. When the first program was launched in 2009, just after the bottom of the market crash, there was tremendous market negativity, money managers had been forced by redemptions and margin calls to liquidate building up large cash reserves and business inventories had been bled down to the bone. In that environment the impact of QE 1 was substantial and increased the inflation adjusted S&P 500 higher by 55%. Real GDP surged higher by 3.3% in 2005 dollar terms and businesses restocked inventories making up almost 3/4's of that growth.
However, the second round of QE only resulted in a 16% push higher for the S&P 500 and 1.01% for GDP. The same was true for the most recent program known as "Operation Twist" (OT) which managed a similar rise of 17% for the S&P 500 and 1.5% in GDP growth. The smaller results were due to a lack of the same catalysts that existed during QE 1. The Fed realizes, and has vocalized, that due to these "diminishing rates of return" of each subsequent program - any future actions must be used strategically, and sparringly, in order to be effective.
During the summers of 2010 and 2011 the economy slowed and markets declined by 15% in 2010 and 19% in 2011. Sentiment became very negative with markets exhibiting high levels of "fear" as measured by the volatility index. The conditions gave Bernanke the ability to launch actions that produced modest results in lifting assets prices and bolstering consumer confidence. The problem that Bernanke faces today is that none of these conditions exists currently. The markets only marginally off their highs, and up more than 8% for the year, there is very little negative sentiment and the volatility index is near its lowest levels. Consequently, most money managers are fully allocated in portfolios, with little cash available, as they have continued to anticipate further Fed action with each piece of negative news.
For Bernanke - the markets continue to do the work for him by rallying on "hopes" of further action. With the markets up, and the economy not completely collapsing, there is little pressure for the Fed to act at the moment. Bernanke currently has the flexibility to wait and see how things develop over the next couple of months. Bernanke will likely wait until the 2nd estimate of 2nd Quarter GDP is released in August before making any major decisions.
If the economy slows as we expect to near a 1% annualized rate then Bernanke will feel more pressure to act. The case for action will be strengthened further if the market has also given up its gains for the year with "fear" gauges and negative sentiment rising strongly.
With earnings season stumbling along on much lowered estimates, economics weakening, no resolution in the ongoing Eurocrisis, employment and the consumer showing signs of strain - there are plenty of catalysts to trip up the market. With the financial markets already pricing in the bulk of any action the Fed might take - Bernanke's only choice currently is to wait and see what happens.