Thursday, December 30, 2010

Did Bernanke send markets (further) tumbling on December 1st?

If market expectations of fed policy changed dramatically on the days previously mentioned, what may have caused those changes?

I previously noted that December 1st an odd day in that expected future fed funds rates and 3 month treasury yields increased despite sharply falling stock prices and longer term bond yields.

I consider this Bernanke speech to be a prime candidate for what pushed markets and monetary expectations in "opposite" directions.

Some notable quotes:
"Amid the bad news, there have been some positives. The pronounced declines in the prices for crude oil and other commodities have helped to reverse what had been a significant drag on household purchasing power through much of the year."

Oh no. Anyone who understands supply and demand knows this is nonsense. The reason oil and commodity prices had fallen was because NGDP was plummeting. (Bernanke knows this, and markets know he knows this, but I'll point out why I think it's significant later)

"At the same time, the increase in economic slack and the declines in commodity prices and import prices have alleviated upward pressures on consumer prices. Moreover, inflation expectations appear to have eased slightly. These developments should bring inflation down to levels consistent with price stability."

Eased slightly? They had fallen off a cliff! By this point they were 0.34% over the next 10 years according to the TIPs spread and were slightly negative according to 5 year inflation swaps. And even looking backward, headline inflation was 1.07% at that point.

The theme of this speech seems to be "Employment, real GDP and every other economic measurement is looking awful, but there is good news... Inflation and commodity prices are really low!" This is exactly the speech markets shouldn't want to and didn't want to hear. Although I doubt Bernanke really believed what he said here, I think this gives you terrific idea of the hawkish stance of the Fed as a whole at that point. If nothing else, this speech showed that Bernanke(who I'm assuming was more dovish than other Fed members) was not going to fight hawkish members of the fed to ease policy.

Anyone looking back at this speech today knows it was a complete disaster. The Fed obviously should have been fighting deflation and looking and falling prices with worry... So how did markets react?

In a perfect world we could compare intra-day fed funds futures to this chart, but I don't believe they are available anywhere. The speech took place on 1:45 PM, so markets falling at about 3 pm seems reasonable(especially since the markets seems to react a bit slower to speeches than to rate changes). The Dow fell 3% seemingly directly in response to this speech (and remember, no other big news events occured that day).

Perhaps more damning is this CNN article titled "Bernanke: Look for programs not rate cuts". If CNN could pick it up surely markets could have and did. This may actually be the strongest evidence that the market was looking for traditional monetary policy over fixes for the financial sector.

Tuesday, December 28, 2010

Evidence that monetary policy was important in late '08.

As a general rule, during late 2008 increases in stock prices were correlated with increases in nominal yields, inflation expectations, and expected future Fed funds rates. This isn't surprising. If the correlation  between expected future fed funds rates and other asset prices breaks down however, it should give some kind of an idea of impact of monetary policy.

There are two very notable days which I believe show the strength of monetary policy during the period. The first (October 28) was positive and the second (December 1) was negative.

1) October 28, 2008. The S&P rallied 10.79%, the 30 year treasury yields rose 7 basis points, 10 year Treasury yields rose 4 basis points, AAA bond yields rose 10 basis points and BAA rated bond yields rose 9 basis points, and the 10 Year TIPs spread increased from .77 to .83. Meanwhile the expected FF rate in December fell from .860 to .825 and the three month treasury yield fell from 0.84 to 0.77. If this were related to some non-monetary shock, FF futures and treasury yields should have risen, not fallen.

I expected that there may have been some bailout or financial news that pushed up markets, but when I looked there was nothing of the sort. News that day noted that... "Stock analysts struggled to make sense of the gains"  but also acknowledged that the Fed may be partly behind the rally.

2) December 1, 2008. S&P down 8.9%, 30 year yield fell 23 basis points, 10 year yield fell 22 basis points, AAA yields fell 25 basis points, BAA yields fell 19 basis points and the TIPS spread rose by 1 basis point. Meanwhile, the December expected FF rate rose from 0.417-0.433, 3 month treasury yield rose 6 basis points and the dollar rose by 0.23%.

Again there was no clear news event that day that would cause such a collapse.

Obviously if you are only looking at days in which monetary policy and markets moved it opposite directions it will, by definition, look like monetary policy matters a lot... but the magnitudes are what are impressive. Those days represent the second biggest gain and second biggest loss in equity prices during the entire crisis!

And what of the biggest gain and biggest loss days? They also seem to be correlated with changes in the perceived stance of monetary policy.

October 13th was the biggest rally of the period (and the fifth biggest rally in the DOW EVER) and, "The surge came as governments and central banks around the world mounted an aggressive, coordinated campaign to unlock the global flow of credit, an effort that investors said they had been waiting for."

And the biggest losing day of the period? Two days later on October 15th. Guess what sent the market tumbling.

"Selling picked up momentum in the afternoon as the Federal Reserve’s chairman, Ben S. Bernanke, cautioned Americans that the bailout would not swiftly lift the economy and that continued weakness was certain."

The selloff seems like exactly the type of reaction one might expect if markets thought the Fed would do what was necessary to prevent NGDP from falling the 13th, only to realize it was hopelessly focused on the financial crisis (and not aggregate demand) two days later. And why would a Fed Chairman ever say continued weakness was certain? If that was the case shouldn't they ease policy?

(Data for the S&P was acquired form Google Finance, Fed Fund Futures data was acquired from the Cleveland Fed, and all other data was downloaded from FRED)