Fed Chairman Bernanke Running Out of Options

Includes: DIA, IEF, SPY
by: Eben Esterhuizen

Rumors of an intra-meeting cut before the official Jan 29-30 gathering refuse to go away. Some traders say that the FOMC will wait for inflation data on January 16 before deciding whether to cut interest rates between meetings, while others say that the FOMC will cut rates shortly after Bernanke's testimony before the house on Thursday January 17. Some analysts worry that the market is just too aggressively priced to disappoint, as futures markets have already positioned for an interest rate cut of 75bps by the end of the month.

"The real problem with the market is confusion," says Doug Roberts at ChannelCapitalResearch.com. "There is concern the government itself is detached from what is going on." In hindsight, if we're moving into a recessionary period or in one, it certainly would suggest the Fed's been too tight for too long. Will Bernanke now take dramatic action, perhaps cut interest rates before the month-end meeting, in an attempt to show the markets the Fed is not out of touch with the situation?

Bernanke's testimony on Thursday looks set to be a big event, and there are signs that the market is setting itself up to be disappointed by the Fed chairman. As an example, when the rumor of an emergency Fed rate cut first emerged at the start of the week, there was a mild bounce on Wall Street. For the second time in four trading days, the S&P 500 gained over 1.0% with net breadth (advancers minus decliners) that was under 250. "Since 2003 there have only been six days where the S&P 500 gained 1.0% or more and breadth was below +250," says Bespoke Investment Group. "Of those six occurrences, four have occurred since August 2007." Monday's stocks rally lacked conviction, sending us an important message: There is a real possibility that an emergency Fed rate cut won't calm market nerves, as these moves may do little to resolve the subprime loan problem fundamentally. Stock markets may sometimes celebrate aggressive monetary policy, but there comes a point when markets realize why the FOMC has to be so aggressive.

The debate over whether the Fed is prepared to cut aggressively has been answered by Bernanke's recent speech, when he said that Fed is ready to take "substantive additional action" to complement recent interest rate cuts. The Fed has been forced into a more aggressive stance simply because the market isn't paying attention to its medium-term forecasts. It's hard to imagine after hearing such strong comments from Bernanke that the Fed will not cut by half a percentage point. Anything less would roil the financial markets. If we assume that the market is in fact positioned to be disappointed by a promise of more aggressive interest rate cuts, Bernanke may have to play all his cards on Thursday to avoid a market meltdown.

But Bernanke is running out of party tricks, as Peter Morici, economics professor at University of Maryland, explains: "The Fed is in crisis, because its mix of policies addresses an old style recession, one premised on inadequate consumer demand but solid financial institutions. This recession has its origins in questionable banking practices and a breakdown of investor trust in the integrity of Wall Street's most venerable banks and investment houses."

Running out of options, Bernanke probably wishes an economic-stimulus package could have been a political reality by now. The Wall Street Journal reports that a top House Democrat said Congress and the White House can come to an agreement on an economic-stimulus package - provided Republicans don't insist the plan includes making President Bush's signature tax cuts permanent. But it may be a case of "too little too late." Besides, the delicate negotiations have only just begun.

So, will the Fed cut rates before their Jan 29-30 meeting?

Some say the Fed is unlikely to cut rates before their scheduled Jan. 29-30 meeting, because Bernanke's speech last week already recalibrated market expectations. Of course, this could quickly change if the outlook for the U.S. economy deteriorates sharply in coming days. To some extent, Tuesday's shocking retail sales figures might add weight to the argument for an emergency rate cut. Others feel the FOMC might create panic by cutting rates before their official meeting, because such a move may send a signal that things are so bad they can't wait.

"Those betting on an emergency move from the FOMC seem bound for disappointment, since the meeting date is too close," said Matthew Johnson at ICAP Australia. "The only other way in which they might get bailed out is if the Fed cuts by 75bps on January 30. The Fed hasn't cut by 75bps since they moved to interest rate targeting in the early 1990s, and I don't think that they'll do so now."

Markets may have decided by now that Ben Bernanke is simply Alan Greenspan with a beard. "They've [the Fed] more or less gotten to the right place [with policy]," said Stephen Stanley at RBS Greenwich Capital. "They've just been erratic in getting there." The Fed "has been swinging from one extreme to the other. It's hard to parse out a center of gravity."