Ben Bernanke and the Fed
I thought I could do it. I thought that I could write a piece today that wouldn’t mention Ben Bernanke, the Federal Reserve, QE or “tapering”; I really did. I just couldn’t pull it off.
For the financial world, nothing else exists today. All eyes are on the release of the FOMC minutes, an announcement that, until fairly recently, was seen as the reserve of a few poor demented souls and policy wonks. Now, it seems that everybody has an opinion on the intricacies of monetary policy. Of course it could be that it seems that way to me because I have become one of those poor demented souls. Your presence here would suggest that you may have, too. The vast majority of people in the World are far too busy working, starting businesses, raising families and just plain living and surviving to be eagerly awaiting the words of a bearded man in a suit. Not us, though. For us, the details matter; it’s not just whether the Fed begins tapering but, if they do, then when and how much become important.
It is easy, in the grand scheme of things, to make this obsession with the minutiae of minutes out to be unimportant, but it isn’t. It will have a major effect on markets around the world, and therefore on everybody, whether they are paying attention or not. While the majority of those watching will be looking at the impact on the stock and bond markets, I believe the most interesting opportunities may come from my old stomping ground, the FX market. Currencies react swiftly and violently to any change in market conditions, but the direction is usually logical. It will be this time too, although to understand the initial and long term moves, one must understand the bigger picture.
Conventional analysis would suggest that, should the Fed indicate an end to QE, the US Dollar would strengthen. The logic is simple enough. QE has increased the supply of dollars by around $85 Billion per year. The more there is of something the less that thing’s value in terms of something else. This is as true of the Dollar against, say the Yen as it is of, say, oranges against the Dollar. We all understand that relationship. If bad weather were to result in a reduced crop, the price of oranges would go up; if there were a glut, it would fall. It would be logical to expect, then, a significant move up in Dollar Yen (USD/JPY) when the Fed discusses reducing the supply of Dollars. Here’s what happened last time.
As you can see, since Bernanke’s testimony to congress and the release of the last FOMC minutes on May 22nd, USD/JPY has moved quickly off its highs. Some of this seemingly illogical move is down to a “buy the rumor, sell the fact” scenario. The great Yen short had been going on for some time and it seemed that the world, its mother and her dog were all long USD/JPY. There was little room to the upside. That alone, however, doesn’t explain this move. There is a fundamental reason. The “lower supply” argument above is sound, but it ignores the other half of the value equation, demand.
I have long maintained that there is one new reality in investing that not everybody considers. It used to be that the shifts in capital that mattered were between asset classes. You know, bonds go up when stocks go down etc. This relationship has broken down over the last few years. Rising Treasury yields and a simultaneously falling stock market are more the rule than the exception. Capital has been globalized; money shifts as readily now between countries as it once did between types of asset, and when US assets are out of favor, they rise and fall together.
This explains the drop in the US Dollar following the last FOMC release and gives an indication what will happen this time. QE, by its very nature, increases demand for US assets. Both bond and stock prices are forced up as the Fed creates $85 Billion per month out of thin air and uses it to buy bonds. The potential end to that program made US assets less attractive, caused a flight away from them, and thus reduced demand for Dollars.
I don’t claim to know what the Fed will say today. My spidey powers weren’t strong enough to get me on a wall in the room as the committee met yesterday. What I do know, however, is that in the stock market, as in the USD, any move down as a result of the minutes will be seen by many as a buying opportunity. The Fed will still be there as a backstop, and will begin the dreaded tapering only if improvement in economic fundamentals continues. As this happens it is likely that the capital which had fled to seemingly greener pastures will return. To put it another way, as the rest of the world continues to till the soil, mine the coal and produce things of value, we market watchers will get all excited about something that will quickly undo itself. When I put it like that I feel foolish, but I will still be hanging on the Chairman’s every word this afternoon. I can’t help it.