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.

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