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In Perspective

Unio's "In Perspective" short-form series covers the Unio team's views on topics ranging from investing to business to economics.  


Ben Bernanke: Clint Eastwood? Or the Ventriloquist's Puppet?

John Allison

Stand-up Mr. Chairman!

On June 19th, did the real Ben Bernanke stand up? At his now-famous press conference.

Where he said: the Fed's asset buying will begin winding down - probably starting this year; likely ending by mid-next year?

Where he forecast unemployment hitting the Fed's 6 ½-7% threshold by the end of 2014 - hedged with the usual qualifications.

Where he posited inflation turning up from about 1 ½% (currently) to a more-likely 2%.

Where he envisioned an economy gaining traction, and the environment developing for an eventual rise even in short-term rates - albeit farther into the future?

Did the real Ben Bernanke says this?

US bond markets certainly thought so. The US 10-year bond rose from 2.14% on June 14 to 2.59% on June 25. Bonds from Japan to Germany to the emerging markets all followed suit - with particular upward violence in emerging markets. 

See the chart below:

10 Year Government Bonds (US, Germany, Japan, Brazil)

10 Year Government Bonds (US, Germany, Japan, Brazil)

Clint Eastwood vs. the Ventriloquists.

Or was the Ben Bernanke who spoke that day someone else's Ben Bernanke? What I call the ventriloquist's puppet?

Was he Bill Dudley's, President of the New York Fed's Ben Bernanke, one of the many Fed Governors who hit the speech circuit right after June 19th.

Or David Wessel of The Wall Street Journal's Ben Bernanke who wrote one of many journalistic takes on "why the market misread" Ben Bernanke?

Because there was a surprisingly large band of official, journalist and investment banking commentators who had a message for the world:

Ben Bernanke didn't say what you thought he said.

And what he did say, he said far more gently than you thought he said it.

He didn't absolutely, positively say he would take away the largesse of the Fed's asset-buying program.

After all, did he not say that turning off asset-buying would depend on how conditions looked when the Fed decided to taper?

Did he not say the Fed would leave short-term rates low well after it ended asset-buying?

Did he not hedge his statement with enough qualifiers to guarantee the Fed would not hurt the economy unless the economy was so strong it could not be hurt?

Two messages

I don't blame people for feeling confused by what appear to be two Ben Bernanke messages.

The Clint Eastwood read-my-lips message:

  • We're withdrawing asset-buying largesse, likely starting this year and ending in 2014.
  • Yes, we'll maintain low short-term rates in the meantime.
  • But be aware, we expect the economy to improve and unemployment to fall to our target level of around 6.5% in 2014.
  • Therefore expect that we're at the beginning of the end of exceptional Fed accommodation.

The ventriloquists' puppet's message:

  • Even if we withdraw asset-buying largesse - and we may change our minds if the data tell us to! - you'll barely notice.
  • Why? Because we'll be keeping short-term rates low for as far as the eye can see.
  • The economy is improving but just remember we're a data-driven Fed and the data on things like unemployment will have to beat us over the head before we raise rates by one basis point.
  • We are so far from the end of Fed accommodation you should really not worry. We'll be holding the economy's hand for as long as it needs us and that may be a very long time.

I vote for Clint Eastwood.

I don't buy the ventriloquists' puppet. Why?

  1. Because Ben Bernanke has two strong professional/personal motives for being Clint Eastwood.
  2. Because bond, currency and emerging markets are sending strong signals that they're listening to Clint Eastwood, not to the puppet — and those markets have a direct interest in which is which.

And while parsing Fed statements is largely a waste of time except for certain types of traders, in this case, if Clint Eastwood is the real Ben Bernanke, there are major implications for world markets worth enumerating.

Bernanke's motive: staying true to a communications policy he invented.

Ben Bernanke's first strong motive for actually saying what he means is a communications policy he invented — a policy of the Fed's saying it like it is in an effort, over time, to reduce market volatility.  

Ben Bernanke's Fed is not your father's Fed. His Fed uses words to affect reality by saying what it means. Your father's Fed used words to obscure reality - to give the Fed Chairman a thick curtain behind which he could hide much of what he really intended.

The last thing a man would want, who completely shifted Fed communication policy to one of transparency, is to be misunderstood.

Bernanke's second motive: not being one-trick-pony "Helicopter Ben." 

Bernanke's second strong motive is his legacy: to be the Fed Chairman who both saved the US from collapse (in 2008) and put it on the road to non-asset-bubble health (post-2013).

Ben Bernanke is clearly a dovish Fed Chairman and has put together a dovish Fed Board of Governors. 

Most would agree that his extreme dovishness after September 15th, 2008 — metaphorically dropping dollars from a helicopter — saved the US and the world from financial meltdown.

Many — at least those close to markets the way we are — would also agree that the Fed's highly accommodative policies have been the main driver of stock-market gains.

They've revived the housing market. They've contributed to an increase in the wealth effect. They've helped decrease in debt levels. They've stimulated economic growth.

 A two-trick pony legacy

And the next-to-last thing a man like Ben Bernanke would want is to be known as in the history books is the man who saved the US from collapse in 2008 but who set it in on a path to yet another bubble and future collapse.

 After all, didn't his predecessor suffer for being the magician who expanded the US economy from 1987 through 2006, only to be vilified for setting the US up for a huge bursting financial bubble?

From a purely personal perspective, does it not make sense that Mr. Bernanke, knowing that the end is approaching for ultra-easy money, would not like to secure his legacy as the one who saved the US from almost-certain meltdown in the dark weeks after September 15, 2008 but also didn't go too far and put the US back on a more restrained monetary course? I believe it does.

By signaling he will be pulling in the monetary largesse, his can be the legacy of "Balanced Ben" — the one who let out the stops when they needed letting out, but began pulling them in before it was too late. A two-trick pony! And all the more important if a super-dovish successor to Bernanke takes over the Fed and does author a new bubble!

The vigilantes have spoken.

In addition, people who have a direct interest in long-term interest rates - owners of long-term bonds and owners of currencies around the world - the so-called bond and currency vigilantes - have all responded to the Clint Eastwood version. They have bid up long-term interest rates in the US, in developed markets abroad, and especially in emerging markets. They have also, on balance, bid up the US dollar in relation to most other currencies as well.

But what about the US stock market? isn't it giving the opposite signal? After initially falling — June 18 to June 24 — it's been up since. Isn't this evidence that the real Ben Bernanke is the ventriloquist's puppet? Isn't the fact that the S&P 500 got a 1% boost on July 11, the day after Ben Bernanke answered a question at a Cambridge, Massachusetts event that was interpreted as his going back on his read-my-lips stance, proof that he is the puppet himself! Possibly. But very unlikely. Because when you listen to what Bernanke says at every new event he goes to, he says exactly what he said at his June 19th press conference. Exactly. 

My view is that stock-market investors have such a vested interest in Bernanke's words not spooking the stock market they engage in enormous verbal exertions to project on to him and his words a meaning which is clearly not there.

12 implications

Fed lip-reading typically represents a low-return use of time for us at UNIO.

But in this case what Bernanke has said has had, and will have, real implications. Twelve implications. Implications that are already changing the landscape of world markets.

They are:

1. A one-time hit to the bond markets - in the US and, to some extent, abroad. For example, the yield on the US 10-year Treasury has risen from a low of 1.62% on May 2 to 2.53% on July 16 - a 56% increase.

2. A change in the relationship of real (after-inflation) interest rates around the world - with some countries' real rates going up relative to others'.

  • For example, when Bernanke spoke on June 19, the latest inflation rate in the US was 1.4% and the US' real inflation rate had risen from about +0.12% (1.62% 10-year Treasury yield minus 1.4% inflation) to +1.13% on June 21 (2.53% 10-year Treasury yield minus 1.4%) — a gain in the real rate of +1.01%.
  • In Germany, using the same quick-and-dirty method, the real rate had risen from -0.34% on April 30 to +0.22% on June 21 — a gain of +0.56%.
  • In Japan, the real rate had risen from +1.25% on May 6 to +1.57% on June 21 - a gain of +0.32%.
  • In other words, US real interest rates as of June 21 were up +1.01% versus +0.56% in Germany versus +0.32% in Japan in the period from about end of April/beginning of May.

All this may sort out differently in time, but there will be big changes in the relationships in real rates among different geographies.

3. A change in real rates among different geographies will change currency relationships among these geographies. For example, over time and with the usual temporary fake-outs, the US dollar ought to strengthen versus the euro, the yen and especially against emerging-market currencies if this change in real interest rates is not offset by some other factor — which I don't see now.

USD vs. Major Currencies

USD vs. Major Currencies

4. Change in real interest rates in different geographies will cause money to flow out of markets where real interest rates and currencies are worsening and into markets where they are doing better. For example: out of Brazil; into the US.

  • Around June 19, Brazil's inflation rate was 6.50%. Its 10-year bond: 4.47%. Its real rate: -2.03%. On top of that its currency was weakening. At the end of April one US dollar bought 2 Brazilian Real. On June 21 one dollar bought about 2 ¼ Real. Understandably, funds will flow out of Brazil where real rates are negative and the currency is weakening into, say, the US where real rates are positive and rising and the currency is strengthening.

5. The Fed has reduced the odds of medium-term future inflation. Inflation may rise in the shorter term. The Fed is predicting that — say from a 1.4% inflation rate to 2.0%. But in the medium term less Fed largesse means higher interest rates which will dampen inflationary expectations.

  • Higher long-term rates will by themselves — on the margin and ever so delicately — dampen the intent to raise prices (if you're a company) or the expectation of higher wages (if you're an employee) or the ability to attract foreign capital (if you're a capital-hungry country like an emerging market).

Many investment watchers who have predicted sharply higher inflation and have, so far, been incorrect will have even less confidence in their thesis. One result will be the continued fall over time of such ant-inflation proxies as gold.

6. The Fed has reduced the rate of near-term emerging markets growth. Long-term US interest rates rising has made it more expensive for emerging markets to attract foreign capital.

  • Much of the growth around the world over the past decade and a half has been driven by money capital funding fixed capital (plants, roads etc.) which has driven demand for the whole food chain of materials from metals in the ground to heavy equipment that is required to build fixed capital items like plants and roads.
  • The central driver of this demand has been China.
  • Because of optimism over emerging markets growth — with China at the center - foreigners lent lots of foreign currency to emerging markets - debt that must now be paid back.
  • Emerging markets from Brazil to Turkey to Indonesia are all affected — especially those with large current account deficits.

7. The Fed has removed an important tailwind to stock-market appreciation — the tailwind of its massive buying of fixed-income which has both reduced the interest rates on these assets and put liquidity into the system thereby encouraging the diversion of liquidity into the stock market. This doesn't mean the stock market will necessarily decline. It means that, increasingly, increments in stock market prices will depend more on factors like company earnings and less on factors like Fed tailwinds.

8. At the same time, the Fed has created better longer-term conditions for stock market appreciation by putting a bit more of an underpinning under the market's price-earnings ratio.

Contrary to myth, the stock market does not do well in periods of high inflation and does do well when inflation is low and steady. So anything the Fed does to dampen future inflation expectations through higher rates should translate into a somewhat higher market price-earnings ratio. The Fed's announcement is a harbinger of better economic times in domestic USA. Ben Bernanke put himself on the line: the economy will strengthen over the next year and a half and unemployment will fall to around the 6 ½% mark that the Fed believes is consistent with a withdrawal of asset purchases.

  • This is a prediction not a promise and, as all things are in this Fed, "data dependent" - but it's a significant prediction.
  • This doesn't mean the economy will improve every month in a straight line. It means that Bernanke believes the economy has momentum.
  • When you change policy you have to do so ahead of when the momentum has reached the peak you're guiding to - not when you've reached that peak.
  • By the way, better economic times does not move in lock-step with better company earnings.
  • Even when the economy is growing, earnings can slow because profit margins compress. Profit margins can compress because the mix of sales changes for the worse - for example, fewer sales to China and more in domestic USA might not be good for any given company's mix of profits. Also, profit margins can compress because labor costs rise which in turn can happen because there are more bottlenecks in finding specific kinds of workers.

10. The Fed's unlocking higher long-term rates will provide more fixed-income competition to stocks. When the US 10-year Treasury was 1.63% as it was on May 2 it was less competition for an S&P 500 whose dividend yield is about 2.17% than the 10-year Treasury is today with a yield over 2.50% and an S&P 500 dividend yield of 2.04%.

11. The Fed's ushering in higher long-term rates makes life easier for Japan and Europe and especially for their central banks.

  • Higher US real bond rates makes it easier for Mr. Kuroda to close the gap between Japan's very high real rates and US real rates (the gap has already shrunk from more than 1% to a ½%.
  • Higher US real bond rates have also widened the gap between German and US real rates so that today German real rates are about ¾% less than US real rates.
  • In both the Japanese and European cases their lower relative real rates is one good reason their currencies will weaken.
  • And that is one good reason exports will grow more than they might have in Japan and Europe.
  • What's more, higher US real rates makes monetary easing in Japan and Europe all the more likely and effective because neither area will be competing with the US as the latter starts its gradual monetary wind-down.

12. Finally, the Fed's move is a shot across the bow of government  executive and legislative branches. The shot telegraphs the following message: we, the Fed, are gradually passing the baton for fixing the economy over to you, the fiscal authorities, who have been able to avoid the hard decisions heretofore. Wake up! This is not an aggressive message. This is not an aggressive Fed. But it's a message nonetheless.

Consequences. And truth?

These are 12 consequences playing out from the Fed's June 19th statement, Ben Bernanke's same-day press conference, and all succeeding Bernanke appearances including his current — mid-July — testimony before Congress. 15

Why has it been so difficult for people to see what is before their eyes?

  • First, transparent communication is a relatively new phenomenon at US, and now other major, central banks. People steeped in decades of Delphic-speak can't quite get out of their heads that the head central banker needs to be interpreted, not just listened to.
  • Second , people in markets have agendas and they are often not your or my agendas. For example, if you own billions of bonds would it be in your interest to talk bond yields down by telling us the Ben Bernanke's comments are really not a big deal. Of course.

The monetary air-mattress

Even those who believe the Ben Bernanke's remarks are much ado about very little, get their ultimate consolation from the fact that the Fed, in Bernanke's own words is not on a "preset course" — in line with its data-dependency posture.

But the Bernanke Fed has always been data-dependent. There is no consolation here. What's new is that Bernanke thinks:

a) the data will change for the better and

b) he will do certain things that raise interest rates if it does

That's new. And to believe it's not significant is to believe Bernanke is wrong on the future data. Certainly possible. He has been before.

But why is it am I not thrilled knowing that I am waiting for data to arrive that is only good if it proves Bernanke wrong?

 — John A. Allison

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