Markets dissapointed as FED`s Bernanke hints no QE3

Just as expected, no new news came out from Chairman Bernanke today, as he delivered his testimony to the Joint Economic Committee of Congress. He instead focused on reassuring financial markets that FED is ready to act in case of an European financial meltdown and plead against fiscal tightening. As an immediate result, gold plunged by $40 to $1592, and the S&P went down to $1321. Markets need their daily dose of stimulus talk Bernanke!

QE3 and Operation Twist

It was to be expected that in testifying before the Congress, Federal Reserve  Chairman Bernkanke will not signal a further strengthening of FED`s balance sheet expansion policy. He never used this venue to express and make public changes in the FED policy and probably never will. Instead, investors will focus on the June 19 - 20 FOMC meeting where its members will decide if the current shape of the US economy warrants more easing. A great deal of weight will come from the disappointing job figures: the economy added the fewest jobs in a year in May. The initial claims printed at 377k, while the last week`s initial claims were revised up from 383k to 389k. Part of the drop in unemployment seems to be explained by the 140,600 people who lost their extended unemployment benefits as the 99 week period expired.

Bernanke announced on the 1st of March 2012 that FED will adopt a balanced approach of price stability and full employment, which they consider to amount to a jobless rate between 5.2 and 6 and an inflation rate of close to 2%. While the official inflation rate seems to be stabilizing around the 2.5% mark, the official unemployment rate is stubbornly hanging to the 8.1% mark. 

 

This means that the Federal Reserve may be tempted to go for employment boosting measures like continuing the Operation Twist which aims at decreasing the long term borrowing costs, by shifting the FED holdings of US treasuries from short maturities to longer maturities, or even some further source of cheap credit for the banking sector (be it QE or some other term that would mask that the ultimate purpose of it all is inflation). Because treasuries are generally thought as a measure of the risk-free rate and serve as a benchmark for corporate debt, this measure in theory would also decrease financing costs for companies.

Depending on what the outcome of the Greek elections will be, FED will probably also need to expand its emergency liquidity programme to beleaguered South-European countries like Spain, Portugal and Italy and possibly have to increase its EUR/USD swap lines with the ECB to cover the capital loss of the ECB from the defaulting Greek bonds. 

US Debt ceiling ludicrousness

But irrespective of what happens in the next months, one thing is certain: the US will breach the previously agreed debt ceiling of $16.394 trillion, right before the November elections. If the discussion of increasing yet again the debt ceiling will be hijacked, automatic spending cuts of $500 billion would be enacted. According to a ZeroHedge article, the D-day may well be the 14th of September this year. From Zerohedge:

It`s a dangerous game that FED is playing. For once, the exit strategy from this expansionary policy may be harder to implement than it may seem. At one point FED will have to reverse their stance and go for higher interest rates to cool of inflationary pressures. But, once awoke, the inflation squid is notoriously hard to put back to sleep. Secondly, maintaining such low interest rates, skews risk perception at the corporate level, mainly because low interest rates may determine investments in projects that would bring low profits (and that would go underwater if the interest rates would shift from 5.50%, the current Corporate Bond Weighted Average Interest Rate to say, 10%. Low funding costs stimulate investments of all types, and malinvestments today will most certainly trigger defaults at some point. Thirdly, this is not anymore a matter of the economy responding to FED policy announcements. It is a game of expectations, and the current expectation is for QE3 in 2012. The current market trades less on economic fundamental than on QE3 expectations. We may well see the S&P drop to $1150 if Bernanke fails to provide markets with their much needed fix.

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