Forget the Weak Economy, Market Finds Faith in Fed

Investors took hope from Fed Chairman Ben Bernanke's speech Friday.

The red-hot bond market tumbled while stocks gained.

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.

New York Stock Exchange Traders
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New York Stock Exchange Traders

"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 500surrendered 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.

"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 growthindicated 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.

Bernanke speech "a call to action"?

Phil Orlando, chief equity strategist at Federated Investors in Pittsburgh, said investors now may start cycling out of defensive areas such as consumer staples and health care and into industrials and technology after a miserable month.

"Investors have clearly priced in a worst-case result from an economic standpoint, and if we get any positive surprises from economic data marginally, that may draw some money," Orlando said. "When you've got eveyrone else on the other side of the boat, the opportunity to snap back from left to right is potentially pretty strong."

Yet Wall Street showed Friday that no one was giving the all-clear signal: Bernanke's promise of an active Fed coupled with the GDP surprise against estimates only boosted the market 1 percent or so, reflecting continued concerns over the economy.

"If the economic conditions get a lot worse, the Fed would announce a new program of Treasury bill/bond purchases and probably put more weight on explicit monetary targets, in the same way the Japanese did," wrote Paul Ashworth, senior US economist at Capital Economics in London.

"When you've got eveyrone else on the other side of the boat, the opportunity to snap back from left to right is potentially pretty strong." -Federated Investors, Phil Orlando

"Depending on the scale of buying, that might drive a range of long-term rates lower through the portfolio balance channel," he added. "But the impact on the real economy would probably be pretty muted."

Nomura Securities in New York saw the Bernanke speech as "a call to action" for the troubled economy, and predicted a higher chance of Fed movements.

"Markets were looking for reassurance from Bernanke today, and the Fed chairman did not disappoint," said Nomura economist Zach Pandl. "His speech strengthens our conviction that the FOMC is likely to ease policy further in the relatively near future."