Mike’s Financial Pocket – 06/21/13 – Bernanke’s Blues

What the heck happened on Wednesday after the Fed meeting?

Helicopter Ben Bernanke promised to keep the pace of bond purchases going steady. That is, the Federal Reserve promised to print $85 billion per month to buy mortgage bonds and US Treasury Bonds, continuing with its “Quantitative Easing” policy. Bernanke also promised that the discount and federal funds rate would not be hiked unless inflation “soared” passed 2% or unemployment dropped to 6.5%.

All in all, the Fed promised to maintain the status quo, for the time being.

So, why the drop in the markets on Wednesday and Thursday? I think the folks over at Business Insider nailed it.

The initial leg down in bonds came right after the release of the FOMC statement and updated macroeconomic forecasts at 2 PM ET. The FOMC is more optimistic on the economy than before, which means tapering back of bond purchases under the central bank’s program of monetary stimulus will probably come sooner than previously expected.

O.K. Pretty standard stuff in the Fed statement. The economy is getting better, slowly. The Fed will continue bond purchases. Yadda, yadda, yadda.

The second, more notable, leg of the sell-off was triggered around 2:45 PM by Bernanke’s response to a reporter’s question about the sell-off in the Treasury market over the past several weeks that has sent bond yields soaring.

Bernanke said, “Yes, rates have come up some. That’s in part due to more optimism – I think – about the economy. It’s in part due to perceptions of the Federal Reserve. The forecasts that our participants submitted for this meeting, of course, were done in the last few days, so they were done with full knowledge of what happened to financial conditions. Rates have tightened some, but other factors have been more positive – increasing house prices, for example.”

Again, this is the standard stuff that we have been hearing from the Fed since QE2 and Operation Twist. And then, the shoe dropped:

Then, Bernanke concluded, “If interest rates go up for the right reasons – that is, both optimism about the economy and an accurate assessment of monetary policy – that’s a good thing. That’s not a bad thing.”

Not only did Bernanke appear to endorse the bond sell off by suggesting that interest rates are rising for the “right reasons” (which I will pick apart in a bit) — Bernanke essentially told the market that at this point, the Fed is not going to be the “white knight” who swoops in and saves the financial damsel in “distress,” as it has done oh so frequently since March of 2009 with its money printing.

The market did not like this statement. In just the last hour of trading on Wednesday, the DJIA dropped 150 points, or about 1%. The bloodbath continued on Thursday, with the Dow dropping 2.34%. Now, the Dow has given up all of its gains in the month of May.

To me, Bernanke is trying to ween the market off of Quantitative Easing by (comically) suggesting that rising rates for the “right reasons” is a natural, good, or even a free market (lulz) phenomenon.

Ben Bernanke

Oh, Ben.

Bonds are selling off because there is a fear that there will not be enough buyers of United States Government debt without the Fed. In other words, investors and foreign governments may be growing tired of lending money to the United States at such low rates when the federal government racks up the enormous deficits year after year, let alone our $100,000,000,000,000 in unfunded liabilities. When bond prices drop, the yield (interest rate) rises. Ben is technically right when he says that if bonds are rising for the “right reasons,” that’s a good thing. The “right reasons” are a free market and an expanding economy. We haven’t had right reasons since 2007 (and that’s being very generous).

The problem with the nonsense talk of “the right reasons” is that the bond market is very likely just reacting to upcoming withdrawal of Federal Reserve support. In other words, less money being printed is perceived as a negative for bonds and stocks. This is not a “natural” phenomenon. A healthy market without government intervention is a natural phenomenon.

In a normal market, stocks would be the better investment if they appreciated (both through price appreciation and dividend yields) at a significantly higher level than “safe” investments such as US Treasuries. So, if 10 year Treasuries are yielding 1.8% (like they were a month ago), stocks are a much more attractive investment. However, if interest rates rise significantly, people may be tempted to shift money back into bonds because the higher yield will give them an adequate return without the risk inherent in stocks.

This is not the situation we find ourselves in today.

In today’s “market,” government bonds have been supported by the Fed purchasing them. If the Fed stops buying them, there may not be any buyers out there at the still low rates bonds are commanding today. This could cause a dramatic price drop in bonds.

Is that what Ben wants? Possibly — if the money will flow into the stock market and give America the economic boost it needs. The question is, will it? Or will we have situations like today where bonds and stocks drop in price? The other question: if the money flows into the stock market and other parts of the economy, will we see the kind of inflation some have been fearing for years?

Government-supported markets are just delaying the inevitable.

As always, free markets are better markets.