Thursday, January 10, 2008

Bernanke Put

After a nice late day rally yesterday, stocks had been struggling this morning as retail sales at the major retailers were fairly disappointing. But now, our friend Mr. Bernanke has spoken and markets have made a fair turnaround. Whether stocks can hold the gains or not is far from certain (indeed as I write this, the market seems to be selling off a little) but certainly the odds of a 50 basis point cut at the next Fed meeting have increased considerably with this speech. And that has gold making new highs again.

Some excerpts with my comments in bold:

Since late last summer, the financial markets in the United States and in a number of other industrialized countries have been under considerable strain. The turmoil has affected the prospects for the broader economy, principally through its effects on the availability and terms of credit to households and businesses. Yeah, when folks start to default, banks become rather reluctant to lend again.

In all likelihood, the housing contraction would have been considerably milder had it not been for adverse developments in the subprime mortgage market. Since early 2007, financial market participants have been focused on the high and rising delinquency rates of subprime mortgages, especially those with adjustable interest rates (subprime ARMs). Currently, about 21 percent of subprime ARMs are ninety days or more delinquent, and foreclosure rates are rising sharply. It seems to me that the contraction would not be so bad if the Fed hadn't kept rates too low for way too long (which fed the bubble) and had taken some action on sub prime when it was happening rather than waiting until it was a problem. In other words, if the bubble hadn't gotten so big to begin with, it wouldn't be so far down to reality.

As you know, the losses in the subprime mortgage market also triggered a substantial reaction in other financial markets. At some level, the magnitude of that reaction might be deemed surprising, given the small size of the U.S. subprime market relative to world financial markets. Part of the explanation for the outsized effect may be that, following a period of more-aggressive risk-taking, the subprime crisis led investors to reassess credit risks more broadly and, perhaps, to become less willing to take on risks of any type. Investors have also been concerned that, by further weakening the housing sector, the problems in the subprime mortgage market may lead overall economic growth to slow. The problem is not that investors are reassessing credit risks; the problem is that they are just now considering credit risks. The fact that most of these sub prime mortgages were part of triple A rated securities is what has investors pulling in their horns. Investors need to know what the hell they are buying so they can assess the risks.

However, in light of recent changes in the outlook for and the risks to growth, additional policy easing may well be necessary. The Committee will, of course, be carefully evaluating incoming information bearing on the economic outlook. Based on that evaluation, and consistent with our dual mandate, we stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.

Financial and economic conditions can change quickly. Consequently, the Committee must remain exceptionally alert and flexible, prepared to act in a decisive and timely manner and, in particular, to counter any adverse dynamics that might threaten economic or financial stability. This is the money graph. The phrase "substantive additional action as needed to support growth and to provide adequate insurance against downside risks" is the one everyone is concentrating on. Adequate insurance is basically the Bernanke put and substantive additional action means 50 basis points is on the table.

This is probably not enough to make a long term bottom for the market. I am looking for a consolidation period in which we continue to trade in this range we've been stuck in for the last 6 months. Commodities are still acting fairly well if extended in price. Further monetary easing should continue to support the commodity markets.

No comments: