Markets Waiting on Bernanke's Every Word

The market has stumbled in recent days even as the economic news has been highly positive. On Thursday, 3Q GDP came in at +3.5%. On Monday, the October ISM Manufacturing index came in at 56. Tuesday morning we had the news that Berkshire Hathaway (BRK.A) will be acquiring railroad Burlington Northern Santa Fe (BNI) for $100 a share in cash and stock - a 31% premium to Monday’s closing price. Warren Buffett said this represents a long term bet on the U.S. economy.

Yet stocks are selling off when you’d expect them to move higher. Not only that but volume has returned to the market of late with NYSE Composite volume in excess of 6 billion shares 3 of the last 4 trading days. We haven’t seen that in a few months. The Volatility Index (VIX), commonly called The Fear Index, has spiked 50% towards 30 in just the last couple of weeks. This suggests many pros are buying put options to protect their profits or even speculate on a decline in stocks.

Barron’s technician Michael Kahn went so far yesterday to call the end of the rally:

The stock market’s astounding run from its March lows has finally run into a real ceiling. After outpacing most, if not all, post bear-market rallies over the past century the inevitable is finally here.

- “Setting The Bears Free”, Michael Kahn, Barron’s Online, November 2

I’m not completely convinced as we’ve seen corrections of this kind during this rally before, but the market action is certainly suggestive.

*****

Wednesday is a very important day as the Fed will announce its decision on interest rates at 2:15pm EST. There is consensus that there will be no change in policy but everyone is focused on the statement. There has been a lot of talk in the last week or two about a Fed exit strategy. The question is whether such a concern will find its way into the statement or not.

The key sentence is:

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period (FOMC Statement September 23).

An important column by Fed insider John Hilsenrath in yesterday’s Wall Street Journal had this to say:

Long before the Fed moves, it will need to communicate its intent to investors. The first step will be tiptoeing away from saying rates will stay low for an extended period. The communication strategy is likely to come up at this week’s meeting, though it remains unclear when a change in the wording will happen.

- “Fed’s Path To Higher Interest Rates Begins To Take Shape”, John Hilsenrath , The Wall Street Journal, November 2, A2

This is a very delicate situation for Bernanke and Co. and will provide an important window into Bernanke’s mind. On the one hand, the economy and financial markets have stabilized and are showing some strength. Preliminary 3Q GDP came in at +3.5% and Tuesday's October ISM Manufacturing index was the strongest its been in 3 years at 56. Financial markets, as we all know, are soaring. This provides some cover for Bernanke and the FOMC to start at least talking about an exit strategy from their extraordinary policy accommodations one would think.

However, they are also very concerned with spooking the markets. Any selloff in financial markets could damage the real economy and confidence. With the recovery still very fragile, they will want to avoid this at all costs.

I don’t know what Bernanke will do. But whatever he does will be crucial for financial markets and will provide a window into his mind.

I believe that any change in the statement even suggesting an exit strategy would be taken badly by the markets. Everybody knows how dependent this market is on government stimulus and any suggestion that the punch bowl might be diluted at some point in the near future could cause many to leave the party.

Comments

[Denis Gould:]

I expect the strategy will be to talk the economy up as a way of starting to discuss the exit strategy. This should limit the damage in the stock market but should hit bonds hard. Then in a day or so you come back and talk about rates staying low for some time and bounce the bond market. All told you get the subject into the air without too much damage.

Nov 04 03:04 AM

[ryanclarke:]

My prediction: The Fed will do nothing but leave ZIRP in place and continue to "jawbone" as required. The fact every market player stops what they are doing the day of the Fed outcome ... and the market flatlines for a few hours ... should tell everyone this institution has too much power over the U.S. stock markets ... but I predict if the Fed keeps ZIRP in place for another six months ... the Fed will finally become "useless" to the markets.

Nov 04 12:10 PM