Investors Are Showing They're Not Afraid of the Fed

Despite a fairly aggressive round of Fedspeak, investors are paying only moderate heed to the notion that a change in policy is likely any time soon.

The Federal Reserve headquarters in Washington, DC.
The Federal Reserve headquarters in Washington, DC.

Recent remarks from Federal Reserve Chairman Ben Bernankeand several other central bank officials sparked concern that interest rates may have to rise in order to stem inflation and defend the softening US dollar.

But market behavior in the face of all the talk indicates a belief in more of the same: accommodative monetary policies that lead to a weak dollar, which in turn boosts all asset prices and helps pull the economy, at least for the moment, out of the worst pullback since the Great Depression.

"Taking a historical perspective, we're a long way from an exit. The point in time for an exit strategy won't came until the second half of 2010," said Kurt Karl, chief economist at Swiss Re in New York. "You're just not rolling along strongly enough to contemplate an exit strategy."

Bernanke's remarks Thursday that the Fed would begin tightening as the economy recovered drew only modest reaction Friday. Stocks rose slightly, as did the dollar, while bond prices slipped.

The strength of the dollar is important these days to Wall Street, which is counting on a weak greenback to keep export prices low and stimulate growth.

In fact, the bottoming of the dollar and the beginning of the seven-month stocks rally happened nearly simultaneously in March.

The PowerShares US Dollar Index Bullish ETF topped out in the early part of that month at $26.75, and it has tumbled almost in a straight line 15 percent lower since then as stocks rallied about 50 percent.

Inverse correlation between stocks and the dollar coincided with strong buying in commodities, particularly gold, which has hit a succession of record highs as the dollar has tumbled.

With a low level of fear about the Fed changing policies, the commodities trade is likely to stay intact.

"For the last six months we've been heavily overweight in commodities—energy and gold," said Michael Church, president of Addison Capital in Yardley, Pa. "It seems to me like sentiment's really shifted now from where we were six months ago. Longer term, these are probably the places to be."

Yet like many market experts, Church worries that the long-term ramifications of the tacit weak-dollar policy could be harmful.

"Maybe some people think you can ease your way to prosperity," he said. "It's really a very simple concept: You can slice a pizza up into a hundred pieces, but just because you get six doesn't mean you're not going to be hungry after you eat them.

"It's working for [some] asset classes, but the risks are larger than anyone gives credit for. At some point down the road, this all ends with significantly higher rates of inflation."

Bernanke acknowledged concerns about rate movements when he spoke Thursday and said the Fed eventually will have to act to temper inflation.

Markets reacted somewhat Friday, sending the dollar nearly 1 percent highereven as stocks posted gains. Commodity prices were little changed, with oil lingering around its recent trading range and gold easing off its powerful rally this week.

The reaction was far more muted than last week, when Fed governor Kevin Warsh wrote in the Wall Street Journal that tightening could be on the way, and perhaps even before the market is ready.

Investors may have turned savvy that even if officials are giving some heed to the need for a stronger currency, that day of reckoning is still not near.

"With everyone trying to call a top (in the dollar) and sentiment so overwhelmingly one-sided, we're taking that in contrary fashion," said Richard Sparks, senior analyst at Schaeffer's Investment Research in Cincinnati. "It's going to be a while before we see the end of this run."

Some analysts in fact are altering forecasts to reflect that the Fed may sit on its hands even longer than the late-2010 estimate that seems to be in vogue among rate-watchers.

"We are extending our Treasury rate forecast out to 2011 and making mark-to-market adjustments to our 2009 and 2010 views," Ethan Harris, global economics analyst at BofA-Merrill Lynch Global Research, wrote in a note to clients. "We do not expect the Fed to raise rates until at least 2011 though the market may anticipate a number of rate cycles before the Fed actually moves to raise rates."

Indeed, any fear the market may have shown during last week's saber-rattling wasn't in evidence this week.

"They might be trying to jaw-bone, and good for them, but it seems pretty toothless," Kim Rupert, managing director at Action Economics in San Francisco, told Reuters. "I do think the Fed needs to start talking up an exit strategy. I think we could see an improvement in all the markets actually."