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In general I'm a numbers guy when I analyze the possible outcomes of market movements, looking at potential changes in macro-economic numbers to ascertain movements in the stock and treasury markets. But over the last few years, as politics has infused itself more into economic policy, I've had to switch my focus to anticipating changing political dynamics, and how they affect markets.

As the Fed's successive iterations of the QE policy multiplied, I have looked at the political pressures surrounding the Fed to see if any policy change was likely. I felt that so long as President Obama and the majority of Congress supported Bernanke in pursuing his extraordinarily loose monetary policy, it would continue. But, when it was suggested that Bernanke would retire in 2014, I wondered if any cracks might appear in the Fed's mantra of endless free money. The Fed, like other organizations, is, within its own walls, driven by the internal concerns of its members. These dynamics have generally not been focused upon by the media.

During Bernanke's tenure, individual Fed member's votes seemed to be viewed as expressions of their own economic philosophies. When the Fed voted on a policy decision, it was generally presented as unified action with Bernanke at the helm. Dissenters' views were often portrayed as irrelevant to the Fed policy being implemented. Fed minutes, which were supposed to provide an inside look into Fed discussions and debates, seemed to portray members as coalescing around clearly stated points of view. These debates appeared academic. It seemed clear that the doves were ultimately in charge of Fed policy.

This changed with the confusing minutes from the December, 2012 meeting. Some believe that the tone of the December meeting was a one-time event and that future Fed meetings will be less chaotic. My view is that the tenor of Fed meetings in 2013 will be similar to the December meeting until a new chairman is chosen. Policy statements resulting from these meetings will be more ambiguous and confusing, likely leaning toward the hawkish side, given the range of possible outcomes.

In October, 2012 reports that Bernanke would retire might have been a threshold event. The chairman, the creator, champion and ultimate defender of the Fed's hyper-loose monetary policy, would leave the institution, which he had redefined. But, when reports of Bernanke's potential departure first appeared the Bond market stayed relatively sanguine. Vice Chair Janet Yellen or another ideological dove was likely to replace him. But that was before the re-election of President Obama, the near collapse of the fiscal cliff negotiations and the daily escalating vitriol in Congress which has the left the political process nearly paralyzed, and Congress engaged in a fiscal civil war. The upcoming battle over the debt ceiling could leave the government in a financial gridlock, where performing its basic financial function will be an ideological struggle. In this polarized atmosphere, if the Obama administration were to nominate another ideological dove to replace Bernanke, the choice could be politicized. The nomination of a new Fed chairman could become another flashpoint. This would feed more uncertainty in the Treasury Market.

The stakes surrounding Bernanke's replacement are high. GOP Conservatives such as Ron and Rand Paul have been extremely critical of the Fed. I take this to mean that they accuse the Fed doves of being enablers of an ever escalating US deficit and debt. In contrast, Democrats and their supporting economists, such as Paul Krugman, view Bernanke's loose monetary policy as a necessary support of the economy. In addition, an unspoken benefit to the Democrats of nearly zero interest rates is that they can continue their agenda of high spending to satisfy their constituent's needs with relatively little debt cost. Even though Ron and Rand Paul and Paul Krugman may be considered as articulating political extremes, their viewpoints represent the potential polarization of the nominating process. Bernanke's easy money policies have had real tangible effects on political outcomes. Exceptionally low interest rates have made Republicans appear as Chicken Littles when they decry the failure of Congress to cut spending. On a theoretical level, hyper accumulation of debt is a bad thing, but courtesy of the Fed, the American public has been inoculated from it, sparing them from its potentially ill effects. The political result arguably helped re-elect Obama and generate a Republican Congress favorability rating which scrapes the bottom. In this high stakes atmosphere, the nomination of the next Fed chairman could be a political maelstrom.

It's no wonder that Fed members were engaged in rancorous debates in December, 2012 with more concerns about Bernanke's policies being vocalized. The crusader of QE and inventor of perhaps the most experimental monetary policy in American history is leaving while the war in Washington is escalating. In addition, if Congress fails to rein in spending, an escalating supply of treasuries will likely overwhelm the Fed's balance sheet. The doves may be thinking that they're vulnerable. What happens if the new chairman is a less effective advocate of Bernanke's controversial policies? Or, not such a big believer in them? Even if Janet Yellen is chosen, does she carry the same weight in financial circles and Congress to withstand the increasing controversy over her predecessor's monetary experiment? If in retrospect Bernanke's policies looks like failures, Fed members won't have Bernanke present to defend them. The remaining doves at the Fed will take the heat. Fed members will likely protect themselves against this potential blowback now by becoming more hawkish. This is a form of political insurance which the December minutes began to expose. Absent a recession, until a new Fed chair is confirmed, Fed members are likely to sound less dovish. The mother dove is leaving the nest.

In the past, the release of Fed minutes and decisions often precipitated a rise in the equity (SPY) and Treasury bond (TLT) markets. However, I believe things have changed. Until a new chairman is chosen, these markets could see increased volatility surrounding these Fed events. Accordingly, during times when the Fed is releasing minutes and decisions, investors may want to add some protection for their equity and treasury positions.

Disclaimer: Further to any disclaimer for the site on which this article is posted, please be aware that the author is not a registered investment adviser (or representative thereof). The content presented in this article is opinion only, and should not be relied upon by the reader in making investment decisions. The reader should base any investment decisions on his own independent research and analysis entirely at his own discretion and/ or seek advice from a professional. No content published in this article constitutes a recommendation that any particular investment or investment strategy is suitable for any specific person.

Disclosure: I hold positions in the QID, PSQ, SQQQ and SH, which I actively trade. I adjust some of these positions daily. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: Bernanke's Pending Departure Could Exacerbate Bond Market Volatility