Fed's Dilemma: Markets Want Both Growth and Stimulus

Fed Chairman Ben Bernanke's remarks to Congress this week satisfied neither those who believe the economy can stand on its own nor those who want the central bank to continue playing a role in the markets.

Pablo Martinez Monsivais / ASSOCIATED PRESS

A day after most risky assets in the stocks and commodities areas posted losses on Bernanke's remarks, stocks gained enough Thursday to make the Bernanke appearance an even draw.

But behind the trading, Wall Street seemed to want to have its economic recovery cake while it eats more monetary easing, too.

Bernanke delivered what historically had been known as his Humphrey Hawkins remarks to the Senate and indicated that the recent turn in data — manufacturing, housing and employment to name three — gave him confidence that the recovery, while uneven, was a bit better than he had anticipated.

The market interpretation, then, was that the chairman would be advocating no more of the monetary easing that has helped boost risk asset prices. At one point Wednesday, the Dow had fallen more than 125 points before erasing more than half its losses by the close.

The speech interrupted a sharp 2012 rally in stocks, while also triggering an abrupt sell-off in gold and other inflation-sensitive commodities. More broadly, the moves provided indication that the financial markets are still highly sensitive to the Fed's maneuvering.

"The fact that this reaction was mostly negative points to a surprising fragility in the prices of risk assets," Julian Jessop, chief global economist at Capital Economics in London, said in a note.

"In particular, the equity markets appeared to be disappointed that the signs of a stronger economic recovery — previously regarded, of course, as a positive — mean that Bernanke felt no need to signal another round of quantitative easing," Jessop added. "This makes one wonder whether investors would have been happier if the Fed chairman had talked down the economy and suggested that further monetary stimulus will be required."

Such reaction could indicate a market not facing reality, he said.

"The one lesson we would draw is that if equity investors are banking both on stronger economic growth and further monetary easing to support current valuations, they are almost certain to be disappointed," Jessop said.

Traditionally, the second day of the Fed chairman's address is usually less market-moving than the first, and the major averages quietly sloshed around in positive territory Thursday. Bernanke delivered a stern warning regarding fiscal policy, but otherwise avoided much talk about future easing intentions.

That stood in contrast to Wednesday's stock losses as well as a $75 drop in gold [GCCV1  Loading...      ()   ] prices, a move that could be seen as a decrease in the inflation expectations that would come with a third round of quantitative easing .

"The response yesterday was breathtaking in its swiftness and violence and we are convinced that the response by gold and other markets was and is egregiously ill-advised and massively overdone," hedge fund manager Dennis Gartman said in his daily newsletter. "The Fed is not going to take away its punchbowl...but it appears that it will not be pouring anything into that same punchbowl for a while."

The other side of the argument, of course, is that the Fed moving away from its historic market intervention would be a sign of confidence.

Since the financial crisis began, the Fed has staged two QE bond-buying interventions as well as a third program called Operation Twist, which caused no net expansion of the central bank's $2.9 trillion balance sheet but did result in bond yields dropping even further.

"The Fed needs to get out of its crisis mindset," said Jim Paulsen, chief market strategist at Wells Capital Management in Minneapolis. "Would we really be focused on Greece if there was a legitimate crisis here to worry about?"

Instead, Paulsen said the Fed needs to start worrying more about the inflation its policies could cause. Rising bond yields later in the year actually could force the central bank to increase rates rather than go to even more accommodative policy, he said.

"I'm an advocate of the Fed starting to normalize its monetary policy with the economic cycle that's matured from crisis to recovery," Paulsen said. "You can still accommodate, but there's no reason to accommodate it with crisis policies any longer."

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FTSE, DAX, CAC Seen Flat; Markets Watch Liquidity Effort

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Markets Start to Anticipate Obama Victory in November

While President Obama may not be Wall Street's ideal candidate, stock prices are rising on growing expectations he will be re-elected this November.

Part of that, market pros say, is simply that investors feel more certain about who will be in the White House for the next four years and which policies they will have to deal with.

Obama's chances of winning in November increased to above 60 percent on Tuesday, up from about 50 percent at the beginning of the year, according to the odds on prediction market Intrade.com.

Meanwhile, the S&P 500 [.SPX  Loading...      ()   ] has hit a new bull market high and is up 9 percent on the year.

The stock market’s rise comes as the supposed Republican frontrunner, Mitt Romney, continues to struggle to win the GOP nomination.

Romney has just a 55 percent chance of winning Tuesday’s Michigan Primary, down from 80 percent just a day ago, according to Intrade. Meanwhile, the odds of GOP challenger Rick Santorum winning the primary have shot up to 45 percent.

The surge in President Obama’s chances at a second term also have coincided with a string of better-than-expected domestic economic data this year, including an all-important drop in the unemployment rate.

The latest reading of U.S. consumer confidence on Tuesday blew away economists’ expectations. That contrasts with the Republican debates, many of which have centered on social issues.

“The Romney, Santorum, and Gingrich infighting has done irreparable harm to the Republican Party’s ability to present an alternative economic platform to voters,” says Joe Terranova, chief market strategist for Virtus Investment Partners. “As long as manufacturing and other key data continues to improve, the market is growing comfortable with Obama being President again.”

History shows the market tends to rise during election years. Gains tend to be even greater if the incumbent party wins.

To be sure, not everyone is buying the old adage that the “market hates uncertainty.” Some feel it is still way too early to predict what will happen in November and that Obama’s policies will be harmful to business, causing a sell-off in 2013 if he is re-elected.

“As to penciling in Obama, while the market likes certainty, certainty of bad news will not be good for the market,” said Stephen Weiss of Short Hills Capital. “Although the effect of an Obama second term will be muted if economy continues to improve.”

Weiss and others can at least take heart with the Congressional odds.

Intrade puts the Republicans’ chances of controlling the Senate and House after the November elections at 72 percent and 64 percent respectively.

That brings up another Wall Street maxim: “Market likes gridlock.” This way, a single party can’t mess it up.

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ECB's Latest Cash Injection: What Markets Will Look For

The European Central Bank’s first mass injection of cheap money into the European banking system last December was hailed as a success from almost all sides.

The results of the second round of Europe’s answer to quantitative easing , to be announced Wednesday, will be watched even more closely.

The first time around, the market underestimated how popular the three-year long-term refinancing operation (LTRO) would be — and how positive its effects could be — until traders returned to their desks after the Christmas break.

With the second round, there are a number of key questions to ask before deciding how to play it.

How Big Will It Be?

Analysts’ estimates for the second round have gradually been reduced, with most now believing that it will be similar to the first operation of 489 billion euros ($654 billion).

If the sum taken out is below 400 billion euros, this may also be viewed as positive, according to Peter Schaffrik, head of European interest rate strategy at Royal Bank of Canada, as it could indicate that banks do not need the new source of funding.

How Much of the Total Sum Is Actual “New Money”?

In the first operation, banks also slashed their use of the existing Main Refinancing operation and of the shorter, three-month LTROs, in favor of the new facility, making the net increase in outstanding ECB open market operations only around 210 billion euros.

This time around, analysts are predicting up to 300 billion will be new liquidity, as many of the MROs have already been taken out of the system.

How Will It Affect Markets?

In the immediate aftermath of the LTRO, a large takeup by European banks should help boost the recent risk rally in stock markets — which could in the long term help bolster the recovery around the world.

The second round of LTRO will be “almost as important for the U.S.” as for Europe, according to analysts at Bank of America Merrill Lynch.

A lot will depend on how banks use their new source of financing. If they choose to lend it, or to buy sovereign bonds, they could help struggling euro zone economies. If it is used just to bolster their own balance sheets, critics fear it will merely postpone the euro zone’s troubles until later.

The euro should be boosted slightly against the dollar in the short term, unless take-up is much higher or lower than expected, according to Lauren Rosborough, senior currency strategist at Societe Generale.

While there was a boost to peripheral bond yields — which were at close to unsustainable levels for countries including Italy — following the first operation, analysts at Bank of America Merrill Lynch warned that yields look less attractive second time around. The amount banks charge each other for lending should continue to gradually decrease.

When Will It Start Helping the Real Economy?

This is possibly the most important question of all — and the area where the ECB’s action is most open to criticism.

So-called “broad money” and bank lending both rose in January after falling toward the end of 2011, according to ECB data, which analysts at Credit Suisse believe is an encouraging sign that the “disorderly deleveraging” of the European banking system has halted.

Banks also continued to buy debt in troubled peripheral countries such as Spain and Italy, driving down their bond yields. And the deposit outflow in peripheral economies (apart from Greece) also halted following the operation, indicating that some consumer confidence is returning.

Yet the growth in demand for mortgages and other consumer-focused lending is still slowing, and the gloom across the euro zone has not lifted. Most economists still expect the region to fall into recession this quarter.

Ultimately, the most important effect which the LTRO has on the man in the street may be that its bolstering of the banking sector helps make a sustained recession less likely.

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Saudi Oil Boost Could Calm Markets: Schumer

WASHINGTON - The United States should do more to encourage Saudi Arabia to boost its oil production to make up for lost Iranian oil, Senator Charles Schumer said on Sunday, urging renewed diplomacy as a way to ease the run-up in oil prices.

Tensions surrounding Iran's nuclear program have pushed oil prices to nine-month highs, and U.S. gasoline prices have surged, becoming a top political issue in the run-up to the 2012 presidential elections.

A public promise from Saudi Arabia, the world's top oil exporter, to pump oil at its full capacity would calm oil markets as well as gasoline prices, Schumer, the third-ranking Democrat in the Senate, said in a letter to Secretary of State Hillary Clinton.

In the letter, which was obtained by Reuters, Schumer asked Clinton to urge the Saudi government to increase production to full capacity of 12.5 million barrels per day - an increase of 2.5 million barrels.

That would compensate for a reduction in Iran's total exports of 2.2 million barrels per day. Oil sales from Iran, the third-largest oil exporter, face tough new sanctions as a result of the standoff over its nuclear development.

Gasoline prices in the United States are the highest on record for February. The American Automobile Association (AAA) said the national average price hit $3.65 per gallon on Friday, and analysts say average prices could rise well over $4 per gallon during the peak driving season in coming months.

"These skyrocketing fuel prices are directly linked to the global energy market, particularly Iran's recent efforts to manipulate oil prices and the worry of impacts on supply from an escalation of regional hostilities," Schumer said in the letter.

The United Nation's nuclear watchdog last week warned Iran has stepped up its efforts to enrich uranium. Iran has insisted it is developing nuclear power, not weapons.

The European Union will ban Iranian oil as of July 1, and other buyers will face new U.S. sanctions unless they cut back on purchases.

"These market shifts are now hitting Americans at the pump, reverberating throughout the rest of our economy, and threatening our recovery," Schumer said.

Saudi Arabia has privately reassured customers it will pump more oil, and sharply increased exports in the past week, although it was not clear whether the jump would be sustained.

Copyright 2012 Reuters. Click for restrictions.

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China Central Bank Outlines Plan to Open Markets

China should accelerate the loosening of capital controls, its central bank said, in a report outlining the path to a freely tradable currency and more open capital markets.

While China’s economy has grown dramatically over the past three decades, its financial markets have remained mostly closed off from the rest of the world. Opening the capital account would give foreigners far more access to Chinese stocks and bonds and help transform the renminbi into a global currency and potential rival to the dollar.

The proposal signals that officials in favor of bolder economic reforms may be trying to seize the initiative just months before a once in a decade leadership transition is announced.

“This seems to be a very clear timetable to push capital account liberalization,” said Liu Ligang, an economist with ANZ. “The resistance [against] faster liberalization is not as strong as before.”

Such reform carries major risks, potentially undermining the government controls on cross-border capital flows that have shielded China from the global financial crisis and could meet opposition from more conservative officials.

The International Monetary Fund and the World Bank have both advised Beijing to relax its tight investment controls. By trapping money in China, the closed capital account has fuelled soaring property prices and generated inflationary pressures.

The World Bank, in partnership with a prominent Beijing think-tank, is due to release its own report next week calling for more ambitious economic reform in China. Wen Jiabao, China’s premier, has repeatedly said liberalization of the capital account is a government priority.

But currency reforms have only advanced at a crawl. Many officials and government advisers remain worried that the Chinese financial system remains fragile and would be undermined by a hasty shake-up.

Sheng Songcheng, the author of the central bank report, was critical of this cautious approach. “By overemphasizing preconditions [to reform], a gradual approach is easily twisted into a negative, immobile approach, leading to delays,” he said. “Being prudent in opening the capital account does not mean waiting for ever.”

The report laid out three stages for reform. The first, over the next three years, would clear the path for more Chinese investment as “the shrinkage of western banks and companies has vacated space for Chinese investments” and presented a “strategic opportunity”. The second phase, in three to five years, would accelerate overseas lending of the renminbi, especially in support of trade deals.

Longer term, over five to 10 years, foreigners would be given more freedom to invest in Chinese stocks, bonds and property. At present, foreign institutions are restricted to relatively small quotas that are subject to a slow approval process.

Free convertibility of the renminbi would be “the last step” to be taken at some unspecified time, the central bank added, with restrictions on “speculative” capital flows and short-term foreign borrowing.

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