markets to bernanke: no more questions

Markets to Bernanke: No more questions

Commentary: The Fed's Bernanke should listen to the markets
By Tomi Kilgore, MarketWatch
Last Update: 4:13 PM ET Jul 24, 2006


NEW YORK -- If the financial markets told you to jump off a cliff....
There's more to being chairman of the Federal Reserve than analyzing economic data. You have to play the political game with Congress and the financial markets as well.

Former Fed Chairman Alan Greenspan was the master. His words may have been hard for you, me and Congress to decipher, but they were pretty clear to the markets. And if the markets veered off course a bit, Greenspan would get his troops to make the right comments to put them back on track.

The minutes of the Fed's meeting in late June indicated that they weren't sure whether interest rates were restrictive or accommodative. They also suggested that there was still a question about what was the bigger worry, inflation or growth. See full story.

The markets weren't sure either, until Bernanke's testimony to Congress last week. Now they have no more questions for the Fed chief.
Bernanke's purpose may have been to leave the Fed with some flexibility, but in effect, the markets have backed him into a corner. Whatever Bernanke was planning to do, or meant to communicate to the financial markets, is now irrelevant.

The markets believe a slowdown is coming, and mere words will no longer be enough to change the direction. Bernanke has to act by first ending the current cycle of raising interest rates, and perhaps even prepare for something a little more radical.

The Treasury yield curve is now inverted, meaning longer-term yields are below shorter-term yields. But more importantly for the Fed, the entire curve is below the overnight rate.
There's no clearer message than that: overnight rates are now restrictive, and economic growth is now a bigger worry than inflation.

Stocks knee-jerked sharply higher after Bernanke's first face off with Congress, when he said a slowing economy should help contain inflation.

In the two sessions that followed, however, the Nasdaq Composite gave up more than it gained on Wednesday even though the odds of a rate hike in August, according to the fed funds futures market, fell from 65% late Wednesday to a low of 32% on Friday. Read more about rate hike expectations.

Don't think that because Bernanke follows the markets that he's no longer vigilant about fighting inflation. Basically, the market is telling Bernanke that he has already won the fight.
Bottom line, the yield curve has already jumped off the cliff. The Fed has to stop hiking before the economy follows.

Markets matter
Say what you want about the financial markets, but by virtue of their size, their opinions do matter. If the markets believe something will happen, they can bully the economy into fulfilling their prophecy.

But the markets aren't right just because they say so. They follow economic data very closely, but money flows even closer. And money has no pride or bias; all it ever wants to do is grow.
If you keep losing money betting on a normal, steepening yield curve, then it doesn't necessarily matter what the core inflation data is, the curve will invert.

The current inversion may be caused by some other unseen factors, but if it causes the market to believe in an economic slowdown, the slowdown will come.
Companies will be reluctant to assume growth, and stock up on inventory, when the majority of their peers and customers are worrying about deceleration.

And if banks can't make money on loans, because the relative cost of funding keeps rising, they won't feel the need to go out of their way to issue loans, and may start focusing more on making sure the ones they do make pay off -- in other words, a credit crunch. Read more about bank earnings and the yield curve.
We know that Wal-Mart customers have curtailed spending, but Target said so have theirs. Read more about Target here. Read more about the retail sector here.

The housing market isn't slowing, it has already slowed. The Philadelphia Housing Sector Index hit a 21-month low last Friday following disappointing results from two high-profile homebuilders. Read more about D.R. Horton and M.D.C. Holdings.
Advanced Micro Devices was supposed to be benefiting from Intel's company-specific woes, but AMD's latest earnings report suggests weakness is more widespread. Read more about AMD's results.

It's difficult to say if the expectation of a slowdown caused the slowdown, or the other way around, but does it really matter? Bernanke needs to defibrillate the markets' expectations.
There is some historical precedence for the Fed to placate the market.

When high-profile hedge fund Long-Term Capital Management blew itself up in the fall of 1998, the entire Treasury yield curve was below the overnight rate. Greenspan's Fed acted quickly by cutting rates a total of 0.75 percentage points in three months, in an effort to avoid a liquidity crunch and stabilize the financial markets.

There is one major difference between then and now. Back then, the yield curve was "normal" -- shorter-term yields were below longer-term yields, and had just been shifted below the fed fund rate. That means the economy was still expected to grow, but that the overnight rate was too high.

So in effect, the current situation is actually more dire. Not only is the fed funds rate too high, but the economy is also expected to slow. Basically, unless Bernanke changes the current course of interest rates, a recession is on the horizon.

No more questions, Bernanke. Just do what you have to do.