Bernanke's muddled message on QE - what it means for equities and bonds
Last week's testimony by Federal Reserve Chairman Ben Bernanke before the Congressional Joint Economic Committee was anticipated beforehand as an opportunity to learn about the Fed's plans for QE (Quantitative Easing - the Fed's bond buying program) over the coming months.
How long would it continue for? Would it be tapered slowly downwards? Are there increasing doubts about continuing past the summer? The markets were watching carefully for clues not just about the Fed's thinking, but also about how the bond and equity markets would react to a change in the rate of QE.
Things started well with Bernanke stating clearly that ,
Recognizing the drawbacks of persistently low rates, the FOMC actively seeks economic conditions consistent with sustainably higher interest rates. Unfortunately, withdrawing policy accommodation at this juncture would be highly unlikely to produce such conditions. A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further (my emphasis added)
That sounded like music to the ears of both the equity and bond bulls. There were probably a few traders out there who thought about turning of their screens and heading off for an early lunch while the Fed remained happily content to keep the 'Great Levitation" act running on for the immediate future.
But then Ben decided to throw a spanner in the works and said during the Q&A portion of his testimony, in response to a question as to whether the Fed may taper QE by Labor Day (beginning of September for the non-Americans) that,
If we see continued improvement and we have confidence that that's going to be sustained then we could in the next few meetings take a step down in our pace of purchases.
Which was the cue for the rapid rise in blood pressure of market Bulls, as equities rapidly sank off their highs, the 10-year Treasury rose above 2% and gold did an about-turn to sink back below $1,400. And if that wasn't bad enough, when the Fed minutes came out there was added cause for concern in the line that said that,
A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome.
So, what was the message that Ben Bernanke was throwing out? Ultimately there was something for both the bulls and the bears, and could be interpreted in a number of ways that fit together reasonably coherently.
But it was also a classic reminder of the need to be honed in 'Fed-speak' (yes it exists! - look it up on Wikipedia for some great quotes), as best illustrated time and again by former Fed chairman Alan Greenspan. In one of his best ever quotes (and probably close to being the best quote by a Central Banker in history), though it has been quoted in several variants, he was reported to have said that :
I know you think you understand what you think I said but I'm not sure you realize that what you heard is not what I meant.
So, despite there being fuel for both the bears and the bulls, the uncertainty remains as to when QE is going to come to an end. And probably rightly so - there is no point making decisions now that depend on future economic data.
But I think it's more interesting to consider the implications for the markets at the point when the Federal Reserve really does decide to wind down its bond buying, whenever that happens to be. And after putting the following chart together, I think it makes for fascinating viewing. What I have shown is the S&P 500 (SPY) over the last 15 years against the yield of the 10-year Treasury (ITE) over the same time period. The 10-year Treasury is inverted so that a rally in bonds is shown in the same direction as a rally in the equity index.
Traditionally, equities and government bonds move in opposite directions to each other - or in mathematical terms, they are said to be negatively correlated. One (equities) is perceived to be a risky investment that rallies in times of optimism, or 'risk-on', while the other (government bonds) is perceived to be a safe harbor in risky times and a place to put your money when things are looking less rosy.
Up until 2009, the chart reflects this quite nicely - at times when the S&P is rallying the government bonds are selling-off, and the reverse holds true. In fact, you could almost see the two lines up until 2009 as a nice reflection of each other.
But have a look at what happened once the Fed embarked on their first round of QE back in November 2009 (shown on chart). Almost immediately, the traditional negative correlation between equities and Treasuries disappeared completely, and both have rallied in an almost identical fashion. The chart shows very clearly what is meant by the 'Great Levitation' act - the fact that asset prices are being supported artificially with risk having been removed from the table as a consideration for investors.
The big question though is which of these assets has been supported more by the Fed's largesse. My thoughts (and I have written about it in my previous article, is that yields are at a more 'natural' level given the economic climate we find ourselves in than equities. Which suggests that equities are artificially priced, perhaps by as much as 50% from a very rough reading of the chart.
But whether you believe that it is equities or whether it is bonds that are in a bubble, the chart should make for a sober assessment for the fact that when the Fed does pull the carpet out from their great trick, this could all end up rather nastily.
Which brings me round to my final point. Perhaps Ben Bernanke is also worried about how nastily this all may end when QE finally stops. I want to suggest something else about his not-so-clear message to the world's markets about the future path of QE. I'd like to suggest, a bit cheekily, that Ben knew exactly what he was doing with his 'will we stop / won't we stop' message on when QE may end.
You see, Ben, just like everyone else at the Fed (and in the whole investment world in fact), isn't quite sure how markets are going to react when they do indeed call it a wrap on QE. So he thought to himself (and I paraphrase), 'let's just give this a bit of a tester and see what happens if I throw out some doubt as to how long we continue with this bond buying spree..'.
I'm not sure we can trace the resultant sell-off of the Japanese stock markets directly and only to the words of Ben Bernanke. But they definitely played a part. And with the Nikkei selling off by the 11th largest ever in history, more than since the tsunami of 2011 and prompting the brief suspension of trade, I think Bernanke may have been a bit worried by what he saw.
Leaving me to speculate that I don't think he'll be taking the foot of the QE pedal anytime too soon.