Sent: 19-06-2013 13:27:02
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Bernanke Poised to Guide Markets
A slowly growing American economy that keeps the Fed actively supporting markets is getting more applause from traders than a strengthening economy that encourages the Fed to withdraw its support. The critical question: how does the Fed achieve its policy objectives while abdicating its role as chief market prop.
Global equity markets have taken a turn for the worse this month. China, Europe, Japan and the USA all came up with some disappointing data as did Australia. Country specific effects, rolled together, took the steam from global bond and equity markets that had been tracking toward or past record levels.
At the centre of the recent market volatility has been a vigorous debate over whether the US Federal Reserve will reduce its securities buying program which has been running, most recently, at a rate of $85 billion a month. The buying program is widely regarded as having pushed US equity prices to new record levels and forced longer term bond yields under 2%.
In addressing the Joint Economics Committee of the US Congress on 22 May, chairman Bernanke caused some confusion. Some thought he was flagging a tapering of the asset buying program sooner rather than later. Of course, this debate is rooted in the reality that the bond buying programme will stop at some stage. The uncertainty is over timing.
Until Bernanke's comments, Fed governors seemed to have been doing a good job in keeping the markets informed about their intentions. Bernanke had committed the Fed to keeping policy rates low and unchanged through 2014 and then set an unemployment rate target against which people could also judge the conduct of policy and the likelihood of a change in emphasis.
So, now, we are not sure whether Bernanke attempted some deliberate obfuscation to help wean traders off their reliance on the Fed to tell them the direction of asset prices or whether, being a mere mortal, he simply stumbled over his words to give a misleading impression of what he actually wanted people to hear.
What Ben Bernanke says next is more pivotal than usual. The Fed is holding a scheduled two day meeting this week after which it will release its revised economic forecasts and Fed chairman Bernanke will address global markets via a press conference. One way or another, Australian investors should have new information to price into the local market when trading commences on Thursday morning.
Whether the market's confusion is a consequence of a deliberate ploy on the part of the Fed, simply inadvertent or self inflicted anxiety, Bernanke will get asked the question if he does not initiate the discussion himself: when will the Fed begin withdrawing its stimulus and by how much.
The US economy is expanding but not at a very fast pace. Demand for labour is growing but not by enough to cause a material change in the unemployment rate in the short term. Some of the weakness is due to contracting government spending. Private sector employment growth is consistent with the growth in numbers employed in the last two economic recoveries but the manufacturing jobs lost in the recession are being replaced by lower paid service and part time work. The housing market is improving but remains vulnerable to adverse interest rate movements.
In the ideal world, Fed stimulus - acting through more buoyant asset values - gives way to a more acceptable and sustainable growth path in the real economy. Ideally, this would happen seamlessly so that the beneficial effects of Fed policies on equity prices, for example, will be replaced by the effects of stronger earnings growth due to expanding demand from a more quickly growing employed labour force.
At this stage, traders are more fearful of a delayed growth effect rather than the Fed staying in the market too long. Consequently, there is a preoccupation about how interest rates will react as the Fed seeks to reduce its presence in the markets. Do long term interest rates, and especially those affecting real estate, jump sharply or does the change happen gradually to reflect a steady acceleration in economic activity.
Some would say that the policy framework has been defined in such detail that the prospect of a Fed withdrawal must have been well and truly priced into securities. Others are thinking that the Fed risks losing control of the market as soon as it steps back. There has been a hint of that happening already. Bond yields have jumped from under 1.7% at the end of April to 2.2% as speculation about policy tapering has intensified.
There is also some anxiety about what impact rising interest rates will have on equity prices. The best equity market conditions will occur when earnings are accelerating and interest rates remain low. High interest rates should be bad for equities. They constrain demand and cause downward pressure on valuations.
Investors will have to decide whether they will eschew equities if earnings are rising due to faster growing demand simply because interest rates are also on the rise because the Fed is playing a less influential role.
Bloomberg reported this week on data it had compiled showing the S&P 500 has rallied an average of 16% over two years on the last four occasions the central bank has started to raise interest rates. The rationale for this should be straightforward enough: interest rates are likely to move higher in response to accelerating rates of economic growth.
Asset values are not ultimately of any concern to the Fed unless they are thought likely to affect its primary inflation and unemployment goals. To that extent, there will come a point beyond which markets will have to make their own judgements about whether growth is strong enough to sustain market appreciation.
Meanwhile, it is still probably in the best interests of the Fed to ensure excessive speculation about its intentions does not derail its shorter term objectives. That means some clarification about the Fed's view is likely this week. If that does not happen, the Fed will effectively be saying that its market intervention is nearing an end and that the adults in the room will have to fend for themselves. Either way, we should be better informed.
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