As the world waits with bated breath for Mr. Bernanke to tell us what he will do, the market will remain flat but rest assured there are traders that have placed stops above and below the recent range. For what my opinion is worth, I see this as D-day.
I expect an immediate and dramatic sell off if Bernanke disappoints. The market has built in a 10% to 12% premium in recent weeks only, and I repeat only, predicated on QE3 being announced. That premium evaporates rapidly - probably in less than a week - with no QE3 and a good portion of that comes off before the close today as the market recognizes that the Bernanke put has expired.
On the other hand, if Bernanke delivers, I see a less dramatic surge to the upside. Even with QE3, the market still has significant headwinds. Additionally, there are not many economists or analysts that think QE3 will actually work to reverse the problems we are facing today. I suspect there are a lot of traders that will buy an upside breakout, but I also anticipate that they won't have much problem getting a reasonable fill on their orders after the initial surge as there will be an adequate supply of sellers willing to unload on those choosing to buy the breakout. It might well be a "buy the rumor, sell the fact" situation.
I have noticed as the day approaches that the opinion from analysts and economists has shifted more and more to QE3 being a slam dunk. It's hard to find anyone who thinks something is not in the works. It reminds me a lot of the Supreme Court decision on Obamacare. I doubt that anybody forecasted the way the Court ruled in this case. There were a few who thought the Court would uphold the law but not by re-writing the law and making it a tax.
The point is, regardless of a consensus on the matter of QE3 being a sure thing, there is never a sure thing in matters of this nature. Some economists and analysts have based their opinion on the fact that Bernanke used the word "grave" when describing the horrendous unemployment numbers. The use of that word leads them to conclude that Bernanke will do something.
The tendency to focus on a single word extracted from a speech and draw a conclusion suggests a selective reading of the speech looking for clues that support a particular position. All we had to go on when trying to predict the Court's ruling on Obamacare was the make-up of the Court. That is not the case with the Fed's call on QE3. Bernanke has been vocal and open in his comments and we have a lot to draw from. Let's take a look at what Bernanke has said in recent weeks.
After Bernanke's testimony to Congress several weeks back, Darrell Issa, Chairman of the Committee on Oversight and Government Reform, wrote Bernanke a letter asking a number of questions. Bernanke's answer to question 1 gives us a little insight on how he is thinking at the present time:
"There is scope for further action by the Federal Reserve to ease financial conditions and strengthen the recovery. However, because short term interest rates are already at very low levels, additional monetary accommodation requires the use of nontraditional policy tools, such as balance sheet actions or communication about the likely future course of policy.
Moreover, as I have noted many times in congressional testimony and elsewhere, monetary policy is not a panacea, and policymakers in many different arenas should carefully examine the steps they could take to foster a more vigorous recovery."
Bernanke seems to be sending a message here. If the Fed does take action, it can't be interest rate reductions. That is certainly a foregone conclusion as the Fed funds rate is zero. He goes on to say that balance sheet transactions or communication are the tools available. The obvious take away from his statement about balance sheet transactions is QE3 - in other words, expand the Fed's balance sheet by injecting more liquidity into the banking system but Twist was also a balance sheet transaction. It didn't expand the Fed's balance sheet as they sold short-term securities to fund the purchase of long-term securities, but it did require balance sheet entries and is in fact a balance sheet transaction.
Also a telling point in his response to Issa is his mention that monetary policy is not a panacea. He made a similar statement at Jackson Hole and in his congressional testimony a few weeks back. Is it reasonable to conclude that Bernanke is getting a little tired of carrying the weight of the world on his shoulders? In congressional testimony, Bernanke made a plea to Congress to deal with uncertainty on the fiscal side. Chuck Schumer's response to that plea suggests that Congress would not heed Bernanke's advice:
"Given the political realities of this year's election, I believe the Fed is the only game in town," Sen. Charles Schumer, D-N.Y., said. "I would urge you, now more than ever, to take whatever actions are warranted."
"So get to work, Mr. Chairman."
Bernanke's answer to the question 5 of Issa's letter states:
"The influence of the initial phase of the maturity extension program (Twist) is still working its way through the economic system, and monetary policy changes typically take several quarters to achieve full effect on economic activity. Of course the extension of the maturity extension program - announced at the conclusion of the FOMC's June meeting - is still in the very early phases of having its effect on the economy."
In answer to question 16 to Issa's letter, Bernanke states:
"Survey evidence indicates that one important impediment to increased lending today is lack of demand for new loans by qualified borrowers."
This is a telling remark as it relates to additional QE. Bernanke wants and needs bank lending to increase but recognizes that it isn't doing so - not because of the lack of Fed action but due to lack of demand. See this.
His comments regarding Twist still being in an early stage seems to imply that this program needs to run its course before the Fed takes on additional initiatives.
Moving on to Bernanke's remarks at Jackson Hole:
"Estimates of the effects of nontraditional policies on economic activity and inflation are uncertain and the use of nontraditional policies involves costs beyond those generally associated with non-standard policies. Consequently, the bar for the use of nontraditional policies is higher than for traditional policies. In addition, in the present context, nontraditional policies share the limitations of monetary policy more generally. Monetary policy cannot achieve by itself what a broader and more balanced set of economic policies might achieve; in particular, it cannot neutralize the fiscal and financial risks that the country faces. It certainly can't fine tune economic outcomes." Bernanke speech at Jackson Hole, August 31, 2012
Again Bernanke seems to be shifting responsibility off the Fed and on to Congress and the president. His reference to not neutralizing the fiscal and financial risks translates as the Fed can't fix these problems by themselves. He is turning Schumer's statement back on him - in effect telling Schumer and his cohorts to get to work.
A final point - Bernanke does take note of the Fed's actions on stock prices:
"LSAP's (large scale asset purchases) also appear to have boosted stock prices ..."
He goes on in the same paragraph to state:
"This effect is potentially important because stock values affect both consumption and investment decisions."
This is a big take away for the QE3 crowd. It clearly confirms that the Bernanke put has been in place and it is a matter of some pride on Bernanke's part that he has at least been able to manipulate stock prices.
So that gives us an insight into Bernanke's thoughts. What we can draw from this is unclear- a lot more unclear than a lot of the QE3 proponents seem to think. We can certainly draw from this that Bernanke feels that he is getting no support at all from Congress and he is right in this conclusion.
We can also conclude that he recognizes that the problem with the economy has less to do with Fed policy today and more to do with a generally fearful sentiment that has permeated the American people.
Perhaps we gain little in examining Bernanke's statements as we see clues that suggest he can go either way on QE3. I guess the big question is whether or not he thinks he can keep the stock put in place with anything less than QE3. I think not but that is just my opinion.
In the end, I think whatever he does he will get criticized. He is in a "no win" situation here and he knows that Fed policy initiatives have been less effective than he hoped or expected. He admits that the Fed is learning on the fly, and he expresses all the reservations and concerns that we all have on the matter of monetary policy.
One thing for sure - QE3 is not a slam dunk.