Stocks climbed last Wednesday after Federal Reserve Chairman Ben Bernanke hinted the Fed is prepared to buy more government bonds if “deflationary risks” resurface and the economy remains weak.

The market swiftly interpreted Bernanke’s remarks as a potential green light for QE3, and a Bloomberg headline perfectly captured that consensus view: “Bernanke Says Fed ‘Prepared to Respond’ If Stimulus Needed.”¹

But right from the start, this interpretation looked like a case of wishful thinking.

If you read the details of his prepared remarks for the House Financial Services Committee, you’ll see that Bernanke lists “additional securities purchases” as just one of an entire laundry list of options the Fed has at its disposal to deal with slower growth.²

“On the one hand,” Bernanke said, “economic weakness may prove more persistent ... implying a need for additional policy support.” In other words, engage in QE3. However, Gentle Ben has always been good at practicing the art of double-speak. “On the other hand,” he continued, if the economy rebounds in the second half of 2011 in line with the Fed’s expectation, “that would warrant a move toward less-accommodative policy.”³

In other words, the Fed could just as easily begin to tighten monetary policy as pursue additional easing.  

Keeping His Options Open

Bernanke’s remarks were carefully balanced, as usual, between more easy money on the one hand and the Fed’s exit strategy on the other. He delivered a little something for everyone, keeping all of the Fed’s options open.

But the market chose to focus only “on the one hand” — interpreting Bernanke’s comments as confirmation that QE3 was on the way. Stocks and bonds responded accordingly.

Speaking before the Senate Banking Committee just one day later, Bernanke helped clear up the miscommunication by saying “we’re not prepared at this point to take further action.” A Bloomberg headline last Wednesday read: “Bernanke Has No Plans ‘At This Point’ for More Bond Purchases.”⁴

Of course stocks and bonds quickly reversed course after Bernanke’s clarification, adding to already volatile trading conditions last week.

This episode shows once again why investors shouldn’t try to time markets based on short-term noise. In fact, monetary policy comments from the Fed frequently trigger whipsaws in financial markets, with markets moving in no clear direction.

Road Map for Normalizing Rates

Overlooked amid the mixed signals about QE3 was something else Bernanke revealed in his comments: The Federal Reserve’s road map for normalizing monetary policy.

Ever since the Fed resorted to the first round of quantitative easing in the wake of the credit crisis in 2008, economists have been trying to guess when the Fed would begin hiking interest rates again.

Meanwhile, the Fed just keeps repeating the same mantra: Interest rates will remain low “for an extended period.” As a result, fixed income investors have been suffering through an extended period with yields on short-term Treasury bills, CDs and money market funds hovering near zero, apparently with no end in sight.⁵

Historically, the timing of monetary policy tightening can be a key indicator of where we are in the business cycle, which has important implications for every asset allocation decision you make for your investment portfolio as we pointed out in a previous Banyan Market Letter (Issue 24 • July 6, 2011).

While Bernanke didn’t tip his hand last week about specifically when the Fed planned to raise rates — odds are that may not happen until sometime in the second half of 2012 — he did provide a detailed sequence of steps to watch for in advance of the next rate hike.⁶

The Fed’s Four Step Program

The Fed believes that it can hold down interest rates through the quantity of securities it holds on its balance sheet, rather than by resorting to additional quantitative easing. Remember, the Fed’s balance sheet is still bloated with a record $3 trillion worth of assets, including mortgage-backed securities purchased during the first round of QE.⁷

When QE2 ended in June 2011, the Fed said it would continue to reinvest its mortgage-backed holdings as they mature by purchasing more Treasuries with the proceeds. Just maintaining its bloated balance sheet is one form of easing.

Step #1: The first step to watch for monetary policy tightening is when the Fed stops reinvesting principal payments on its portfolio of securities … passively allowing the balance sheet to shrink.⁸

The Federal Reserve Bank of St. Louis releases weekly figures showing the composition of the Fed’s enlarged balance sheet (you can access the current report here). We’ll be watching the details closely.⁹

Step #2: At the same time the Fed begins to reduce the size of its balance sheet, or soon after, you’re also likely to see the Fed “modify the forward guidance” it has been giving after each Federal Open Market Committee (FOMC) meeting.¹⁰

In other words, watch for the “extended period” language to disappear from future FOMC announcements.

Step #3: Next, the Fed should begin to drain reserves from the banking system. Most of the quantitative easing done so far has ended up in the form of untapped bank reserves held by the Fed, rather than money being lent out into the real economy.¹¹

When the Fed starts draining bank reserves, it’s a sign of higher borrowing and lending rates ahead.

Step #4: Finally, an actual increase in the federal funds target rate may not take place right away, but could be the last in this series of steps. Bernanke is on record saying that when the FOMC finally drops the “extended period” language, the clock starts ticking, but the first rate hike may not happen for at least two to three FOMC meetings later.¹²

The FOMC meets just eight times per year, and their next two scheduled meetings are August 9 and September 20. Even if the FOMC changes its tune at the very next meeting — unlikely given the current economic soft patch — it may not be until November at the earliest before a rate hike would be considered.¹³

After this series of steps is complete, the Fed would actively begin shrinking its securities portfolio through outright sales of remaining securities on its balance sheet. This should put some upward pressure on interest rates, but by then, the Fed’s first four steps will have telegraphed this to financial markets well ahead of time.

It’s worth noting that this series of steps describes a transition from the Fed’s current ultra-easy monetary policy to a more “normal” policy environment. It does not imply aggressive tightening.

By the time the Fed begins raising rates, the economic environment should also be shifting from low inflation toward a rising inflation climate. The bond market should pick up on this shift too and the Fed’s moves are likely to be foreshadowed ahead of time by bond yields. Two asset classes that perform very well in a climate of low but rising inflation include common stocks and commodities, as shown in the graph above.¹⁴

Since the stock market is forward looking, trying to anticipate the timing of events six months or so in advance, Banyan’s Core Equity portfolios are already overweight in the two commodity related sectors: basic materials and energy sector stocks, in an effort to take full advantage of the next stage of this market cycle. In the meantime, we’ll be keeping a close eye on the Fed’s road map.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

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The opinions expressed in this newsletter are subject to change without notice and do not represent a complete analysis of every material fact with respect to the economy, industry or investment opportunity mentioned in this report. This information has been prepared solely for information purposes and is not a solicitation or an offer to buy a security, instrument, or to participate in any trading strategy.

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¹ Bloomberg, 7/13/11
² Federal Reserve System, 7/13/11
³ Ibid
⁴ Bloomberg, 7/14/11
⁵ Federal Reserve Bank of St. Louis: Economic Research, 7/19/11
⁶ Reuters: Futures traders cur bets on Fed rate hike, 7/8/11
⁷ Federal Reserve System, 7/13/11; Federal Reserve Bank of St. Louis: Economic Research, 7/19/11
⁸ Federal Reserve System, 7/13/11
⁹ Federal Reserve Bank of St. Louis: Economic Research, 7/15/11
¹⁰ Federal Reserve System, 7/13/11
¹¹ Federal Reserve System, 7/13/11
¹² Federal Reserve System, 7/13/11
¹³ Federal Reserve System, 7/19/11
¹⁴ JP Morgan Asset Management, as of 6/30/11