A Bernanke Put For Bonds?

Includes: SPY, TLT
by: DoctoRx

Introduction: Confidence has been high that the economy is improving and that the stock market is king of the investment hill again. Much of this attitude comes from one way of looking at the Federal government's fiscal response to the Great Recession as well as the policies of the central bank, the Federal Reserve. This point of view has succeeded brilliantly for stock market participants (the longs, not the shorts, of course). "Easy" fiscal policy (deficits) and "easy" Fed policy have for 4-plus years in this view led to the current ascendancy of stocs as the go-to financial asset class over cash and bonds. This in turn has led to some of the views quoted a couple of paragraphs below.

However, there is a less ebullient way of looking at matters, which ties in with Fed words and actions, namely that the Fed has been correctly acting defensively to prevent the sort of deflation that was present after Lehman went down but before QE 1 kicked in during 2009.

This article is a sort of follow-on or bookend to the piece titled Gold 2011, Apple 2012, Stocks 2013? That article focused on the possibility that the U.S. stock market may be reprising the surges in those two assets - and may also reprise their subsequent falls.

This article focuses more on what the Fed may be thinking and how it may react to recent stock and bond market trends.

To return to the lede, a common way investors look at matters now is exemplified by two news items that appeared this past Monday, August 19.

The first one, a CNBC report, presents the view that there's nothing to fear if stock prices drop, but you should consider buying the VXX or VXN to "protect yourself" from volatility (even though stock prices won't go down much). From Traders beware: Six weeks of intense volatility ahead:

A relatively light few weeks of market news might have lulled traders into false sense of security, but one analyst told CNBC investors should now prepare for an intense period of volatility...

You're going to have a near term correction of around 5 percent (in the S&P 500), maybe a little more, in the big picture that's nothing," he said. "There is going to be a realization that despite that fact that the Fed is going to be buying less bonds they are still going to be buying bonds, just at a slower pace. At the end of the day policy is very constructive for equities.

From Bloomberg.com's U.S. Stocks Beat BRICs by Most Ever Amid Market Flight:

Investors are favoring U.S. stocks over emerging markets by the most ever as fund flows and volatility measures show institutions are increasingly seeking the relative safety of American equities.

Almost $95 billion was poured into exchange-traded funds of American shares this year, while developing-nation ETFs saw withdrawals of $8.4 billion, according to data compiled by Bloomberg. The Standard & Poor's 500 Index (SPX) trades at 16 times profit, 70 percent more than the MSCI Emerging Markets Index. A measure of historical price swings indicates the U.S. market is the calmest in more than six years compared with shares from China, Brazil, India and Russia...

"The U.S. is seen as the most stable economy at the moment, and the equity market is viewed as having better prospects than the rest of the world."

And so on.

Trend-following is rampant.

Background: At the end of August of 2008, the general view of the U.S. economy was that it might or might not be in a mild recession. Q2 GDP was preliminarily reported as nicely positive. Much later, it turned out that GDP in Q2 actually had been strongly negative, accelerating downward into August - before Lehman collapsed. But that was a revision which received little mainstream media attention. Thus the mainstream view has been that the events from early September onward came out of the blue. These events included the effective nationalization of Fannie and Freddie, then the collapse of Lehman and the near-collapse of AIG.

In that view, a "normal" recession became "great" only because of an unlucky one-time event, Lehman. Thus "normal" Keynesian policies should come to the aid of the economy once again.

Many people therefore continue to look for a strong recovery right around the corner.

In addition, the opinion is now widespread that there is a "Bernanke (or, Fed) put" under the stock market.

My guess is that the above is an abridged version of how the majority of investors view matters, thus accounting for the prevalence of such articles excerpted above. To generalize, I think that prevailing U.S. authorities are felt to be friendly to stocks, animal spirits and well-managed corporations are felt to be friendly to future business conditions, and the 2001-2 and 2008-9 sharp market downturns are less worrisome than the fear of missing a stock market advance going forward from here.

I am not asserting that the above scenario is incorrect or that the following is correct, but a close look at what the Fed has actually said and done helps lead me to overweight the following, alternative view in my personal investment decisions.

An alternative reality?: In this view, the Fed should be taken at its word, and there is no reason to expect there to be a Bernanke put under the stock market at this level of stock prices and bond yields.

If we go back to QE 2, here is what the Chairman wrote in an op-ed on November 5, 2010:

This approach (i.e., quantitative easing: Ed.) eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

He emphasizes bonds and interest rates a good deal, consistent with Fed comments ever since "QE 1.5" began in August 2010. The Fed is well aware, and has always been well aware, that the equity wealth effect is small compared to the expedient of lower mortgage and borrowing rates.

Those who deride the Fed for allegedly not knowing the data on equity wealth effects are incorrect. I believe the Fed is pleased to see both stocks and bonds "behave."

Now that long-term interest rates are moving up sharply, and are far off their lows while stock prices are at high valuations by historical standards, why should the Fed have any interest in stock prices moving yet higher? Why is it not time for the Fed to move toward a "bond put?"

This alternative view asserts that Fed policy has been defensive since 2008, recognizing the slow nature of the economic expansion, and has been born out of frustration that the economy has not rebounded as expected.

One thumbnail way of differentiating this view from the mainstream view is that in this view Lehman's collapse did not fail out of the blue, but rather that is was not just a sudden unpredictable event, but rather was a likelihood or even an inevitability.

I side with the alternative view in that regard. A worsening recession meant that assumptions that had been made in the preceding boom were finally seen to have been hopelessly incorrect, and multiple large financial institutions were insolvent. An insolvent financial institution cannot make new loans, so a severe and long economic downturn was upon us in any case, in this viewpoint. Note that this never even happened to the big money center banks in the Great Depression, so the situation was dire as soon as the government determined that Fannie Mae and Freddie Mac were insolvent and needed to be placed into conservatorship. Lehman followed very shortly after that definition.

Thus there are Austrian economic aspects to this thinking, meaning that in this view repeated cycles of lower and lower interest rates since 1982 had brought forward so much new production that the Keynesian well had run dry.

Ever since the crisis, the Fed has emphasized that its actions were to "support" the economy, which it views as weak and requiring support. That's a defensive posture. The Fed was not adding monetary fire to a raging economic boom, after all.

Because its view is that the economy's underlying state is weak, the Fed can, I believe, accept normal stock valuations, and has no special interest in encouraging today's high valuations to go higher. What I believe the Fed cannot accept is unaffordable mortgage rates.

Most of what the Fed has been doing is financing the Federal deficit, though it has done relatively little outright monetization of the debt. (That would come from the Fed forgiving the debt, a la the platinum coin idea that surfaced a while ago, or taking more extreme bond-buying measures than it has done so far so that a wage-price spiral gets going.)

We know from the '60s and '70s that deficit spending is no panacea, and eventually led to dollar collapse in the late '70s. The Fed knows this too. It does not want to "go there."

I believe that the Fed wants economic growth, and it wants it much, much more than any specific level of a stock market index.

Fed support of the Federal deficit becomes challenged when interest rates rise. An interest rate rise has at least two direct consequences. One is that government financing costs rise. The second is that the highly-leveraged Fed balance sheet worsens, and the Fed is already technically insolvent. Higher stock prices cannot solve this problem as they are nothing but trading prices. Again, the Fed believes, rightly or wrongly, that low interest rates are key to the economy's return to strength.

The Fed could really use lower, or at least stable, long-term bond prices soon.

ZIRP: This alternative hypothesis/theory allows for the possibility that the Japanese scenario of zero interest rate policy (ZIRP) for the long run has not been ruled out. I see ZIRP as a defensive policy born of crisis and continued due to economic weakness, not an "offensive" strategy of the Fed to inflate asset prices. When ZIRP began, there was ongoing price deflation in the U.S. for the first time since 1948, so near-zero was arguably a market-derived interest rate. at the time. If there were no Federal deficit and no QE, it's possible that there would be zero interest rates in a free economy and that all the bad debts would lead to a deflationary spiral. There is no way to know.

In this view, QE is being continued out of fear the economy is ready to lurch back into recession. The Fed is likely (alternative view) tired of QE, wants an exit strategy, and thus would not mind a stock market setback to cause a flight to "safety" back into bonds. We know that the Fed has also made numerous comments lately about its concern regarding financial market speculation.

It may be relevant that President Obama very recently decried a bubble economy.

Back to interest rates and the current ongoing bond bear market.

As recently as this spring, the Chairman was quite clear that QE aside he was confident that extraordinarily low short-term rates are required for economic activity to carry on well:

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.

The Fed likely feels that further rises in long rates would be akin to Mr. Market removing the Fed's policy accommodation. Whatever policy and/or rhetorical lever(s) the Fed could employ to stabilize bond yields is unknown, but I believe that the Fed is not out of bullets. If stock prices drop for a while in such a bond-supportive effort, so be it. The Fed does not have one favorite child - stocks - and a disliked one - bonds.

Since Lehman, the yields on the SPDR S&P 500 ETF (NYSEARCA:SPY) and the 10-year T-note have tended to converge. They might do so again. If that occurred at current interest rate levels, stocks would have to reset down a good deal. If that occurred at lower rates, then bond funds such as the iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT) might be good buys here, even though the charts look scary now.

Other comments: Ever since the early or mid-'90s, the main game in investing has been asset appreciation. Based on q and CAPE (Shiller P/E10), stocks have been overvalued the entire past 20 or so years with brief returns to "fair value" at the bottom of major bear markets.

There may be growing support for the idea that an economy cannot do well, and has not done well, lurching from one bubble to another. Ideas can become reality, especially when a President takes up that cause. An aging investor base would, I think, look favorably on the idea that a retiree benefits from financial markets that are not casinos everywhere one looks. In this view, bonds could again be the preferred asset class.

Summary: Many stock market bulls are complacent or confident, however one wishes to look at it. There is a common meme that there is a Bernanke put under the SPY. Of course, there is a belief that the long downtrend in interest rates is over.

An alternative view is that the actions of the Fed along with fiscal policy have actually prolonged the recovery, which will take years more to be self-sustaining (whatever that exactly means). In that view, growth will have its ups and downs, but there will be enough downs to matter. Overall, this view allows for the possibility that this current market and economic cycle will end being similar to all the others since 1982, i.e. being sustained by periodic declines in the interest rate structure to yet lower levels.

In conclusion, I believe that there are good reasons to think that any "Bernanke or Fed put" would at this point be in favor of the beleaguered bond complex. Looking out to a possible new recession, even lower lows in Treasury bonds could (not "will") await us in this strange financial landscape.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Not investment advice. I am not an investment adviser.