Bernanke Sets Cat Among the Pigeons

The Federal Reserve delivered a one-two punch to market expectations today. First the FOMC minutes did not appear as hawkish as many expected. Several FOMC members wanted to see more job growth before pulling back on the throttle. Second, Bernanke's comments in response to questions raise doubts over the consensus view among primary dealers, and the market more generally, about when the tapering will take place. 

The consensus that emerged in recent weeks was for the Fed to announce a slowing of purchases of long-term assets at the September FOMC meeting that would begin in October. The market had also moved to discount a good chance of the first hike in the Fed funds rate in late 2014 or early 2015.

Bernanke's comments gave the market reason to re-evaluate. That re-evaluation is positive for bonds and stocks and negative for the US dollar. Bernanke's comments took place after the NY markets had closed, but before the Asian session began. These thin market conditions contributed to the volatility and the magnitude of price adjustments.

Our view has been that the market was ahead of itself and we thought the tapering would come later. We have suggested, drawing insight from game theory, that the Federal Reserve would benefit by allowing the next head of the Federal Reserve to taper and thereby establish anti-inflation credentials that may be important in the coming years. That credential would be wasted on Bernanke, who will go down in history for using unconventional policies to ensure monetary policy was sufficiently accommodative to prevent the Great Recession from turning into (another) Great Depression. 

Bernanke said several things that prompted the dramatic reaction, which took place not on a blank slate, of course, but in the context of market positioning that was inclined to see higher US interest rates and a stronger US dollar.  In fact, earlier this week, the Dollar Index rose to three year highs.  The euro had fallen to three month lows and sterling to three year lows.  

Bernanke indicated that monetary policy would remain highly accommodative for the foreseeable future.  He indicated that jobs market may not be as strong as it looks, due to the decline in the participation rate and other measures of labor market that continue to show unsatisfactory improvement.  

In a tip of hat to Bullard, the Fed President that dissented from the statement of the last meeting because it did not pay sufficient attention to the decline in measured price pressures, Bernanke said the Fed would defend its target from both sides (above and below). 

He did reiterate that the Fed expected that some of the forces dampening price pressures would prove transitory in nature.  Bernanke also suggested it was too early to conclude that the economy has weathered the fiscal tightening.   Lastly, Bernanke warned that the Fed would push back if the market tightened conditions prematurely.  

The euro, which had traded as low as $1.2755-65, Tuesday-Wednesday shot up a little through $1.3200 before the Asian session began in earnest.  This is more than the 61.8% retracement of the decline since last month's FOMC meeting.  Stops were obviously triggered and this served to exacerbate the move.  By the time Tokyo opened the euro was back near $1.3100.  

Sterling had slumped to about $1.4815 on Tuesday and set a low near $1.4845 on Wednesday shot up to almost $1.5200, a little more than the 50% of its decline since mid-June.  It was just above $1.5100 at the start of the Tokyo session.  

The dollar recovered from the mid-June slump that had brought it below JPY95 to trade as high as JPY101.20 on Tuesday and Wednesday.  It fell to about JPY98.30 in the back of Bernanke's comments and recovered toward JPY99.50 by the start of the Tokyo session.    

The dollar slumped more broadly as well, losing ground to the dollar-bloc and emerging market currencies.  US shares rallied in electronic activity and the first Asia-Pacific equity markets to open, started higher, though Tokyo was an exception as the rise in the yen weighed on sentiment.  

Separately, the MOF reported Japanese investors bought foreign bonds last week for the first time in nearly two months.  Foreign investors continued to buy Japanese stocks.  

We are as surprised as any one by the dramatic market response, even if exaggerated in thinner market conditions.  Our big picture view though is unchanged.   We continue to expect the Fed to be the first of the major central banks that will exit the extraordinary easing and that this will underpin the dollar.  We continue to look for the euro to finish the year near $1.20 and sterling near $1.45.  We suspect that euro area problems will intensify again, perhaps after the German election at the end of the quarter.  

We are concerned that Abenomics is largely old LDP wine (of fiscal policy and easy monetary policy), even if on steroids, in new skin.  The structural reforms will exacerbate the surplus savings of Japan's corporate sector without boosting wages or consumption.  We suspect that the international community's tolerance of a weak yen may soften as the Japanese economy remains the fastest growing among the major economies.  We project the dollar to finish the year near JPY101.