March 2012

Looking past the noise of day-to-day market volatility, the investment climate has improved markedly since the end of 2011. The feared collapse of the global banking system has faded with European Central Bank’s Long Term bank funding operation and, while Greece was unable to avoid default, the write-down of Greek debt occurred without the messy contagion that was feared. Given that improved backdrop, investors have pushed the price of the S&P 10% higher through the end of March. Comparatively, the bond market correction has been marginal, at best.

Despite fading systemic risks, economic fundamentals continue to take a back seat to the confusing message coming from the Federal Reserve. Investors have been on edge trying to guess what Chairman Bernanke and his fellow Federal Open Market Committee (FOMC) members are going to say or do. The events of the last few weeks offer a glaring example. Prior to the March thirteenth FOMC meeting, consensus opinion was that the Fed was on the verge of launching additional monetary stimulus. Despite a public debate among Fed presidents concerning the need for additional action, Bernanke, in testimony and interview, eluded that such action was imminent. Investors were shocked that no such action was announced as the meeting concluded and the summary statement was issued. Like a spoiled child denied, investors threw a tantrum and sold stocks and bonds, driving the price of both down sharply. Responding to the ensuing criticism Mr. Bernanke took the highly unusual step of launching a public relations campaign, in an effort to explain why the Fed has kept monetary conditions especially easy and the rationale for additional easing, should they decide to pursue QE3. The first stop was a prime time interview with Diane Sawyer on the ABC evening news. The Chairman’s message was that growth has been modest, unemployment too high, and that he doesn’t want to repeat the mistakes made by the Central Bank during the Great Depression. Overall, the interview did little to instill confidence. The next stop of the campaign was an engagement to teach an undergraduate business class at The George Washington University titled “The Aftermath of the Crisis.” The class offered a before, during, and after summary of the financial crisis including an explanation of why the Fed bailed out Bear Stearns and AIG, while allowing Lehman Brothers to fail. Clearly, Chairman Bernanke thought that detailing policy action to college students would provide a non-threatening venue to explain controversial decisions and, while it was, it did little to restore credibility. During the first seminar he was asked if the Fed was to blame for the housing bubble and he said it was not. At subsequent seminars, he defended quantitative easing and continued to defend the possibility that additional quantitative easing may be needed. With that, speculation that the Fed was on the verge of additional stimulus returned. So much so, that on the eve of the April 2nd release of the detailed minutes of the March 13th meeting, consensus had again shifted to the conclusion that the release would detail how and when QE 3 would be implemented; despite the knowledge that the summary released weeks earlier had already dispelled that notion. Nonetheless, the capital markets were sent into a tailspin again when the minutes failed to detail any immediate plans and instead offered a mildly upbeat report. As if Fed credibility hadn’t been damaged enough, Charles Plosser, the President of the Federal Reserve Bank of Philadelphia was quoted as saying just hours before the minutes were released “I think there’s a scenario where you could raise rates by the end of this year.” The year being 2012, not 2014! Keep in mind that these men and women gather in the same room every six weeks to discuss monetary policy.

Instead of explaining his case to impressionable college students and the former Junior Miss America, we’d like to see Bernanke confront someone with a firm grasp of money and banking. Just such an individual is Jim Grant, author of Grant’s Interest Rate Observer. Mr. Grant was invited to visit the Fed and express his criticisms to a representative of the Federal Open Market Committee. In a 3,700 word speech, Mr. Grant takes the Fed to task, writing that “What passes for sound doctrine in 21st-century central banking—so-called financial repression, interest-rate manipulation, stock-price levitation and money printing under the frosted-glass term “quantitative easing.” A quick “Google” search of keywords “Jim Grant crucifies the Fed” will take the reader to the entire speech, which is well worth the trouble.

As we’ve expressed on numerous occasions, we suspect that the Fed’s ability to maintain an artificially low interest rate is losing its effectiveness. With the economy well down the path of self-sustainability and inflation likely to push higher in the coming months, we expected that bonds will come under increasing price pressure.