Right Said Fed: Why Bernanke Was Right

Includes: DIA, SPY
by: Bernard Thomas

Yesterday, Fed Chairman Ben Bernanke shocked the markets by stating that it might be the unemployment rate which is overstating the strength of the recovery, rather than (the popular view) GDP understating the strength of the economy. We guess that the lack of wage growth or the fact that half of the decline of the unemployment rate was due to labor force shrinkage did not give it away.

The Fed Chairman reiterated the Fed's stance of exceptional accommodation for an extended period of time. He comments were immediately met with criticism from equity-oriented pundits who regurgitated the bile that the Fed is behind the curve. It is the pundit community which is behind the curve. The Fed sees headwinds from fiscal policy coming next year to balance the budget. The Fed knows that China growing at 7.5% (while still good for China) is a major drag on global growth. Europe is a basket case. Spain is the next poster child for dysfunction and there is even talk of problems in the Netherlands.

Hiring we have seen thus far, is simply a rebound from the over-firing which occurred when the global economy was teetering on the abyss in 2008 and 2009, with some normal cyclical recovery hiring thrown in for good measure. Home prices will continue to fall. Food and energy prices will continue to rise, causing further drag to the economy.

The equity markets assumed that Mr. Bernanke was hinting at QE3. It is probably premature to discuss QE3, but he was clearly stating that Fed tightening is not happening in 2012 and probably will not occur in 2013. If the Fed remains accommodative, but does not twist (it is almost out of short-term assets with which to twist), we could see a steeper yield curve with the 10-year note yield rising as high as 2.75% by year end. However, I think oncoming headwinds will keep it below 3.00%. This is good news for banks as it increases their net interest margins. Ironically, this is good for borrowers as banks would have greater incentive to lend. It is bad for LIBOR floaters as a steep curve is death to such vehicles.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.