Bernanke Expected to Deliver Dovish Message

Federal Reserve Chairman Ben Bernanke
Getty Images
Federal Reserve Chairman Ben Bernanke

Federal Reserve Chairman Ben Bernanke is expected to maintain his dovish tone when he speaks to Congress Wednesday, and he is likely to dispel any notion that the Fed is ready to cut back on its easing policy.

The markets have been speculating the Fed could start to gradually cut back on its $85 billion monthly bond buying program, and that view has been furthered by some hawkish Fed officials who would like to see quantitative easing wind down sooner, rather than later.

Bernanke appears before the Joint Economic Committee at 10 a.m. EDT, and at 2 p.m., the minutes of the last Fed meeting will be released.

"The doves are taking back the reins. The hawks had their day in the sun," said George Goncalves, Treasury strategist at Nomura Americas.

"I think the bond market is going to be happy because Bernanke's going to reiterate his dovishness, and he's still cautious, but he's constructive on the economy," said Goncalves. "I think all markets are going to be pleasantly surprised tomorrow. I think the minutes might introduce some volatility because there's definitely tension at the Fed about when to stop and when to do more."

Bernanke is expected to testify on the economy, but he will also be forced to defend Fed policy and explain how the Fed will unwind the policies that have ballooned the Fed balance sheet.

Joint Economic Committee Chairman Rep. Kevin Brady, R-Texas, said he's going to ask Bernanke how the program will be unwound without hurting the economy. "We're going to focus on two things. Where is the economy headed, and where is the Fed headed?" said Brady, appearing on "Power Lunch" Tuesday.

"The Fed has said their policy can't really create strong employment over the long term … I think the results of QE are not what they ought to be. One of the questions is why do we continue it," Brady said. Bernanke's testimony follows a parade of Fed officials in the past two weeks who have provided a variety of conflicting views. They ranged from San Francisco Fed President John Williams, who said the Fed may be able to taper its bond purchases this summer, to New York Fed President William Dudley, who said it is too soon to say how the Fed will adjust its bond buying program.

"Because the outlook is uncertain, I cannot be sure which way up or down the next change will be," Dudley said in a speech Tuesday. "But at some point, I expect to see sufficient evidence to make me more confident about the prospect for substantial improvement in the labor market outlook. At that time, in my view it will be appropriate to reduce the pace at which we are adding accommodation through asset purchases. Over the coming months, how well the economy fights its way through the significant fiscal drag currently in force will be an important aspect of this judgment."

Dudley's comments and also comments from St. Louis Fed President James Bullard that supported quantitative easing helped drive stocks higher and bond yields lower Tuesday. Dudley's view is closely associated with Bernanke. Stocks rallied to a new record, with the Dow up 52.30 points at 15,387.58, its nineteenth up Tuesday in a row, and the S&P 500 finished at 1,669.16, up 2.87 points.

"I think they're laying the groundwork for him. There's talk … that he's going to sound somewhat hawkish. There's no chance," said Dan Greenhaus, chief global strategist at BTIG.

Bernanke is expected to say that the quantitative easing has helped the economy, but he is not likely to discuss much about ending it. "I don't think he'll be direct and explicit, but the gist of his comments are that they're not going to taper anytime soon. He'll probably mention fiscal headwinds again, as restraining growth," said Tom Simons, money market economist at Jefferies.

Bernanke's take on the economy will be very important, since the Fed is basing its easing decisions on the course of the economy and data have been sending mixed messages. Manufacturing-related data have been surprising on the downside, but consumer-related data, like retail sales and consumer sentiment, have been a bit better than expected.

"He'll want to point to the progress that's been made, because it's progress upon which the Fed will make a tapering decision," said Pimco strategist Tony Crescenzi. "The wishy-washy data makes it more imperative that the Fed have convincing evidence of progress before it tapers, because there are still downside risks to economic growth."

Crescenzi expects the Fed to pare back its purchases to $50 billion or $60 billion, once it sees several months of improved jobs data. "That would still represent fairly substantial easing on an ongoing basis," he said. "That's equivalent to about a half-point cut in the Fed funds rate."

Barry Knapp, head of equities portfolio strategy at Barclays, said the market has been adjusting its view, which was impacted by the very weak March jobs report. At that point, market expectations saw the Fed continuing its easing programs at full throttle into next year.

But the March jobs report was revised to 138,000 from 88,000, and April nonfarm payrolls were higher than expected at 165,000 and the unemployment rate fell to 7.5 percent. But Knapp said the Fed might now start to cut back on purchases in the fall instead.

"The market overreached after the March payrolls and pushed tightening out to January," he said. "Now we've got mixed data, but on balance, you would have thought the data would really be weakening and the Fed would be cutting its forecast. That's not happening. They still sound optimistic on growth. The Street had to adjust its expectations from January back to September/October."

"On balance, things seem to be holding up a bit better than you would have expected given a $600 billion tax hike this year, and the overall magnitude of the fiscal drag in the second quarter," Knapp said.

Treasury rates have risen as "tapering" talk has picked up but stocks have held up for the most part, even though quantitative easing is viewed as a positive for stock prices. Rates are also rising with stock prices and on the spotty improvements in economic data.

Knapp said the 2.05 percent high yield range on the 10-year Treasury from earlier this year is a zone that could give the market pause. The 10-year yield reached a high of 1.99 percent early Tuesday, but headed to lows of the day as Bullard and Dudley spoke. It was yielding 1.93 percent late in the day.

"If Bernanke sounds upbeat, I'm not sure that's such a big plus for the equity market because we're getting close to that high in Treasury yields to the point where people will start thinking about policy changes," Knapp said. "I think he's going to avoid trying to say anything, as best he can. But that's typically what he's done when he's gone to Congress, which is basically nothing. Four pages of text with generic stuff in it."

After Bernanke speaks, the markets will be hyper focused on next Friday's May jobs report, since the Fed has targeted a 6.5 percent employment rate. But Knapp said it will be the report after that one, that could sway the Fed.

He is also watching the minutes, expected Wednesday afternoon. "Those minutes were from a meeting before that last payroll report, following the weaker one. Those minutes come out and he's got to set the record straight. I suspect they'll sound relatively upbeat and the market will take that to mean they're getting closer to talking about policy moves."

Another concern of the Fed is that investors are overreaching for yield because its program has helped flattened the yield curve. Stocks have also run higher, without correcting in any major way since November, and the S&P is up 17 percent since the start of the year. Many analysts expect to see stocks continue moving higher, and Goldman Sachs analysts Tuesday forecast the S&P 500 could reach 1,750 by year-end.

"At this point, it would seem to me that the one thing that can stop the current momentum is this prospect of the Fed normalizing policy," said Knapp. "It strikes me that we're at a little bit of an inflection point where we've become pretty divorced from fundamentals when you look at earnings and revisions and all."

Besides Bernanke's testimony, there is also one key economic report. Existing home sales are reported at 10 a.m.

Goncalves said the market's talk of tapering is premature, and housing is a key reason. "Why stop now. Let this thing get momentum," said Goncalves. "The stock market is not the U.S. economy, not anymore. The wealth effect is not trickling down to everyone. It's the housing market that matters most to every American. Why stop now when housing is starting to rebound."

_By CNBC's Patti Domm. Follow her on Twitter @pattidomm