Forget the Weak Economy, Market Finds Faith in Fed

Even as the economy languishes and likely has several quarters of slow growth ahead, Fed Chairman Ben Bernanke was able to convince investors Friday that the central bank will do all it can to help.

The result of his speech, a high point of the week's FOMC Jackson Hole, Wyoming summit, was that skittish investors waded back into stocks after an awful August and simultatenously flocked from the bond market, doubtful that the Fed will start buying long-term Treasurys anytime soon.

In short, the speech provided what a statement earlier this month from the Fed Open Market Committee could not: Assurance that the central bank will step in, but only when it deems necessary, which it clearly does not at this point.

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"The measured approach he's taking is a healthy one," said Mike O'Rourke, chief market strategist at BTIG in New York. "It's not the type that's going to supercharge the markets and help equity returns in the near term. But it will help build the foundation for the future and a steady recovery going forward."

Indeed, Friday's stocks rally could hardly be described as "supercharged" after the Standard & Poor's 500 surrendered 4.5 percent for the month, triggered largely by the uncertainty after the Aug. 10 FOMC meeting.

But it was enough to stoke at least some enthusiasm among equity investors. At the same time, investors poured out of the bonds market, sending the 30-year long bond down more than 3 points in price.

Jeff Cox
Senior Writer
CNBC.com

"He gave the market something on both ends," said Michael Pento, senior economist at Euro Pacific Capital in New York and a frequent Fed critic. "One side was the economy isn't as bad as everybody's saying, and even if it is they'll do whatever they can to stimulate growth and depreciate the value of the currency and create inflation."

Pento said the economy is in fact worse than Bernanke and other Fed officials, such as St. Louis Preisdent James Bullard, claim it to be, but the market is willing to follow the central bank at this point.

"What they're going to get down the road is intractable inflation," he said. "What they've compelled investors to do is get out of fixed income as much as possible, get out of the money markets and put their money in stocks. They want investors to buy assets, to purchase homes and invest in the stock market. Holding money in fixed income in short-term Treasurys is not what they want you to do."

Market pros wrestled somewhat over what exactly the Fed would do should the economy worsen from the slightly better-than-expected 1.6 percent gross domestic product growth indicated in Friday's data.

The consensus remains that the main weapon the Fed would use is buying Treasurys to drive down lending rates, while cutting the interest paid to banks on deposits and tweaking the "unsually low for an extended period of time" interest rate language remain lesser possibilities.

"Since Bernanke was not ready, at this forum, to signal a move toward an easing bias, he had to deliver the message of faith in the economic outlook," Michelle Meyer, economist at Bank of America Merrill Lynch, told investors in a research note. "If the data continues to weaken, particularly the labor market, we believe Bernanke will pull the trigger for easier policy."

For stock investors, the fallout from the Fed's backstopping of the market could mark a return to risk after Wall Street has been in the throes of a market correction since mid-April.

Investors have been piling out of equities and into bonds, taking $1.4 billion out of equity funds and putting $2.9 billion into bond funds in the past week alone, according to Lipper data. For the monthly reporting period ended Aug. 20, equity funds lost $7.4 billion while bond funds gained $24.1 billion.