Aug

29

This purpose of this post is to help me think out loud more than anything else, and as always, I would love anyone's feedback/discussion on any points mentioned here.

Going into the Jackson Hole meeting, the market had a range of expectations around A) to what extent is Bernanke a "dove" and how urgent another round of stimulus would e; and B) to the extent that Bernanke's trigger finger is itching on the next printer cartridge, what political constraints might force Bernanke to stimulate less than what he'd prefer, given his extremely dovish writings, speeches, and policy history — and the surrounding context of 58 percent Greek government bond yields, negative Tbill rates, BNY offering negative interest rates on institutional cash deposits, and Italian government bonds beginning to trade lower despite the ECB's recent intervention?

The market sees Bernanke as an ideological dove, driven by a zeal to correct the great imbalances of the "global savings glut" (FX surpluses, and trade and employment deficits, spawned by artificially cheap Chinese currency). He can correct that imbalance by devaluing the USD; but quantitative easing is the only tool available to him to devalue the USD. The level of USD devaluation required to normalize China's balance of trade is extremely large (over 20 percent), and would require larger and larger successive iterations of QE to accomplish.

Since Bernanke believes a significantly cheaper USD is in the long-run interest of the country, and QEs of larger size devalue the USD more than smaller-size QEs, Bernanke wants to pursue QE only at such times when the political environment will grant him the most sweeping authority possible, to implement the largest QEx possible, to devalue the USD as much as possible. In other words, to seek further iterations of QE only at the points of maximum panic among the financial and political establishment. This strategy worked somewhat effectively in March 2009 and August 2010.

Having established a framework that Bernanke is ideologically extremely dovish, several events curtailed Bernanke's political latitude going into Jackson Hole 2011.

First, less than a month ago, the Republican frontrunner for president said it would be "treasonous" for Bernanke to enact a third round of quantitative easing. No Fed chairman has ever served in office against the wishes of the sitting President, and the Fed would lose market credibility if it were seen as not having the confidence of the President — or a realistic potential future President. Bernanke cannot simply ignore that comment. Even if it was a 'rookie comment' by a relative newcomer to the Republican race, the candidate (Rick Perry) was playing to a very strong strain of anti-Fed, anti-Wall Street, anti-financial establishment sentiment among the lower/lower middle class of the country, especially the white lower middle class that is the Republican Party's political backbone. Bernanke can't ignore that constituency, at least not indefinitely. Second, the Fed did announce a mini-QE by pledging low rates until mid-2013. However, that had little effect on the market when it was announced — suggesting the market would be unmoved by non-drastic Fed action. Thus, Bernanke would have had to do something drastic — further testing the Fed's political limits — to enact a policy that would suitably impress the market. Third, industrial commodity prices (oil, food, etc) remain relatively high, despite the recent hot money de-risking across all asset classes. Fourth, despite the -10% August, there is not a sense of panic, fear, or clamor for action from American investors outside of Wall Street. In 2010 the situation was arguably different — there was a more acute bear market in the aftermath of the flash crash. Fifth, Narayana Kocherlakota, whom the market perceived as a moderate dove, joined Fed hawks Fisher and Plosser in dissenting from the Fed's pledge to keep short rates near zero for another 2 years. The Fed has not had 3 dissents since the early 90's. This marked a high in terms of dissent against Bernanke's dovish inclinations.

For these reasons among others, expectations going into Jackson Hole were low, although in my opinion there was consensus on some kind of "Operation Twist" duration extension of the Fed's balance sheet.

The Fed in turn produced nothing tangible, other than a promised 2-day FOMC meeting on Sept 20-21 (longer than the customary one day) to "allow for wider discussion of the various tools at the Fed's disposal." Wink, wink, we are going to have a really big surprise for you on Sept. 21, wink wink!

The market immediately interpreted this as a green light that some variant of "Operation Twist" would go forward — whereby the Fed would sell short-dated Treasuries and buy long-dated Treasuries, thus extending the maturity of its balance sheet and increasing the money supply by forestalling until a far future date the time at which its holdings would run off the balance sheet. The S&P proceeded to rally all day long.

Two things about the market's bullish reaction puzzled me.

One, if the Fed really intended to do something inline with market consensus, why wait? Bernanke has harped on the need for "good communication" between the Fed and the market, in contrast to Greenspan, who seemed to enjoy jolting the market with indecipherable musings that served no purpose besides Greenspan's ego. The market expected something concrete out of Jackson Hole. Why not give the market something concrete out of Jackson Hole, then, unless Bernanke is waiting for something to happen between now and September 21 that would give him more latitude to act? Does he feel that he does not have enough latitude

Two, duration extension would be highly negative for banks' earnings, because it would effectively flatten the yield curve even further, depressing financials' earnings when Bank of America is already contemplating another capital raise, and European financials are trading within distance of their 2008 lows. There would be no less stimulative way of increasing American money supply than by flattening the yield curve, which as I understand, duration extension would do. Given the fearful macroeconomic environment, why would the Fed settle for such an impotent way to expand money supply?

Bernanke had no reason to do anything other than telegraph exactly what his next step would be. The fact that he didn't is important, and in my opinion suggests one of either 2 things: either that Bernanke expects something to happen which will give him more leverage between now and 9/20, to enact more drastic policy than current politics allow; or that he feels that current conditions simply aren't ripe for him to implement a further iteration of QE, at the size he wants, relative to what he thinks the political climate will tolerate.

Either way, it's bearish for the market.

What do you think?

Gary Rogan responds: 

The market decided his impotence is bullish. Lack of liquidity doesn't seem to be the cause of the current problems. More liquidity wouldn't help. The market is somewhat confused, in that there seem to be at least two camps/thought processes that interpret his impotence in diametrically opposite ways. The bearish camp is more emotion-based and thus faster in in its response, so the market first essentially gapped down, and then recovered. This is analogous to a response of a human being to a perceived potential threat that is recognized by the thinking brain to be not a threat after the initial fight or flight response.


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