Market volatility increased again last week and while I could point to a lot of different factors, I think the most important one was the uncertainty produced by the musings of Ben Bernanke. I along with everyone else – and that should have been a warning sign – believed that Bernanke would come to the press conference with the purpose of soothing markets that had suddenly decided to move in more than one direction. Well, as I’ve said many times, when everyone expects something, watch out, because it probably won’t happen. Bernanke’s press conference and the statement from the FOMC meeting did nothing to soothe markets and I can’t help but think that is exactly what he intended.

Bernanke may not know much but he should be very familiar with asset bubbles and their consequences. Based on the plethora of conflicting signals he sent last Wednesday there is no doubt in my mind that he had become uncomfortable with the trajectory of certain asset prices and decided that a little opacity about the Fed’s intentions was just what the bubble doctor ordered. Bernanke has, from the beginning of his tenure, stressed the importance of transparency about Fed intentions. I and others have argued that transparency is over rated when it comes to monetary policy and it appears that Bernanke is starting to see the limitations of telegraphing the Fed’s every move. When everyone knows what the Fed will do next, they act in ways that undermine the Fed’s ability to affect the economy and can also undermine financial stability. In short, for monetary policy to be effective, the Fed needs to retain the ability to surprise the market.

The problem with telling the market that interest rates will stay low for a long period of time is that knowing that reduces the urgency of taking actions dependent on credit. If you are considering buying a home or a car and expect to finance it, why rush when you know the Fed is there to watch your back and keep interest rates down? In an example from the last crisis, why worry about getting longer term capital to finance your balance sheet when you can just keep rolling overnight loans at the low, Fed suppressed rate? Of course, that means you are vulnerable to a liquidity squeeze but why worry about that when the Fed has promised to tell you before they do anything that might cause a problem? Lehman is the poster child for Fed transparency.

So, last week Bernanke put a little fear, a little uncertainty in the market. Interest rates have been rising but Bernanke didn’t seem to have a problem with that at the press conference stating that some of that was probably due to better growth expectations and downplaying the idea that the Fed was responsible. And given those increased growth expectations, Bernanke indicated that the tapering of QE was still fully on the table and expected to start this year, dependent on the actual performance of the economy of course. Stocks didn’t like that but after a 20%+ run over the last year, a 5% pullback isn’t something Bernanke is likely to lose sleep over. In fact, with junk bonds  and stocks cooling off a bit, Bernanke is probably quite pleased with himself. We’ll see how he feels if this turns into something more significant. I, for one, have little faith that the Fed has as much control over markets as they seem to think.

Bernanke is right that the markets have been signaling higher growth ahead. Rising bond yields, falling inflation expectations, a rising dollar and rising stocks are all signals of better growth expectations. What those rising expectations are based upon is, as I’ve said before, a bit of a mystery but that is what the market seems to be saying right now. What we at Alhambra are concerned about is whether those expectations are justified and we keep coming up empty when trying to see the future growth everyone else in the market seems quite sure about. So what does last week’s stock selloff say about those growth expectations? The best interpretation I can come up with is that the market believes tapering of QE will be a negative for growth. I saw several articles last week that implied that the sell off was an indication that the market had lost confidence in the Fed but it seems to me that belief in Fed omnipotence is very much alive and well.

I don’t believe QE has been nearly the spur to growth that everyone else does but that doesn’t really matter when it comes to setting stock prices. Stock prices are set by the marginal buyer or seller and he/she obviously believes in the efficacy of QE. The confusing aspect of last week was that bonds sold off at the same time as stocks. If stocks have been rising due to rising growth expectations and bonds have been selling off for the same reason, shouldn’t they have both reversed course last week? Well, maybe but I think there are other forces at work in the bond market that have nothing to do with US growth expectations.

China last week had a spike in their overnight lending rate to above 25% that signals some pretty severe stress in the banking system. China’s problems are not confined to China though and all the emerging markets took this as a bad sign. Brazil is ground zero for the emerging emerging market crisis with demonstrations across the country last week. One can only assume that millions of demonstrators are unlikely to imbue foreign investors with any confidence in the future growth prospects of Brazil, especially if China is tanking too. That being the likely case, the central bank there will probably find it quite difficult to arrest the decline of the Real. The link to the US bond market comes through emerging markets’ holdings of US Treasuries in their currency reserves. To defend their currencies it seems only logical that they will eventually be forced to liquidate some of their Treasuries to fund the likely futile exercise.

Emerging markets have over the last decade or so become major holders of US Treasuries. Brazil owned $250 billion in April 2013 so they aren’t likely to run out soon but if capital continues to flee, those Treasuries will be sold. They already have an inflation problem – that was the source of the protests – and a falling Real will only make the problem worse. Selling Treasuries – dollars – to buy Reals would seem a logical course of action. Will China find itself in the same boat? It certainly isn’t out of the question if their credit bubble is finally popping. Capital has flowed into China due to its perceived growth prospects but if it was built on credit – and it was – and that is ending, the capital may just flow right back out. Yes, I know they have capital controls but I’ve never known any country that had effective ones.

Japan plays a role in this too. A falling Yen makes the Japanese, at least theoretically, more competitive with the other Asian exporters. What benefits accrue to the Japanese through a cheaper Yen come from their neighbors. If capital flows toward the best growth opportunities, Japan’s competitors are looking a little less enticing today than they were a few months ago and their currencies are at risk. These countries have accumulated US Treasuries to keep their currencies from rising too much due to capital inflows so when the flow reverses, the pile of Treasuries will surely be affected. China, Taiwan, Hong Kong, Singapore, Thailand and the Phillipines hold $1.8 trillion in US Treasuries between them. That’s a lot of potential supply that could hit the US bond market. That in addition to the fact that they’ll have little reason – or wherewithal – to show up at auctions of new Treasury debt makes the selloff in bonds look logical regardless of what is going on with the US economy.

Bernanke last week introduced some much needed uncertainty into the market and the stock sell off was a reflection of this renewed uncertainty regarding future Fed actions. The question is whether Bernanke and the Fed will be able to control the fallout. Will their actions accelerate economic activity in advance of higher interest rates? Or will higher interest rates choke off the already feeble recovery? How will the troubles in emerging markets affect interest rates and the dollar exchange rate? If stocks keep falling, I suspect that Bernanke and Co. will decide at some point that the economy and the market just can’t handle the truth and go back to speaking in soothing tones. In other words, this probably isn’t the end of the Bernanke put, but it appears the strike price has changed. What they will do if it goes in the money I don’t know but I think we probably ought to prepare for that possibility.

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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773. You can also book an appointment using our contact form.