Recent market activity

I am by no means a financial guru.  I understand economics, some investing theory and philosophy.  So what I'm good at is understanding things by first breaking them down into their component parts and gaining insight.  Often times you have to discard existing frameworks of thinking and start over again.

Well, last week our friend The Beard (aka Ben Bernanke) held a news conference on his take on the economy and his expectations of "letting off the gas" on "QE" (quantitative easing).  The resulting reaction by the markets was an acute downtrend on all three major indices as well as bond prices collapsing.  A lot of people in the precious metals market were confused why the price of gold, and silver, also dropped very significantly.  After all, if people are moving out of stocks and bonds, why aren't commodity prices rising?  After all the money has to go somewhere right?  Not necessarily.

What happened most likely spooked the market speculators in all markets (stocks, bonds and precious metals) and they all poured into cash and want to wait it out.  Keep in mind now, the Federal Reserve hasn't done anything.  The chairman was just speaking and that's all it took for the speculators to be spooked and sell their positions.  They wanted to be the first ones out before the mass exodus.

That's sort of what I wanted to illustrate here.  A lot of confusing signals occurred after The Beard had spoken.  All the normal activity evaporated and a lot of trends were bucked.  I like to envision the market as a glass of both oil and water.  In its natural state, the oil sits on top of the water, the way it should.  However, what the Fed Chairman did was equivalent to shaking up the glass and now there's oil and water all mixed in together.  If your scope is limited to just inside the glass, things are in a confused state and the oil mixed together with the water doesn't make sense.  But as time progresses, things go back to their natural state and the oil begins to rise above the water.

The question is, what state are we going to be returning to?  There's no real baseline for a so-called "natural" state since the the market is heavily manipulated by the Fed.  But what options do the Federal Reserve Board have?  I would say little to none.  Ever since the '08 crash, the Federal Reserve started QE1, QE2 and QE-Infinity.  They are buying $85 billion of MBS each month.  It's obvious the market can't even tolerate the mentioning of scaling down.  Remember, Bernanke didn't talk about selling their bonds.  They will continue buying bonds but at a slower rate.  This means their balance sheet isn't shrinking.  It's expanding.  They've added more than $3 trillion to their balance sheet since '08 and it will have no choice but to keep it up and perhaps even increase their MBS purchases.

As of now, the bond prices haven't recovered yet.  The 30-year bond yield rose 16 basis points since Bernanke spoke.  Mortgage rates on a 30-year fixed is now above 4%.  The bond speculators were definitely spooked by the news conference and the only way to entice them back in is for the Fed to reverse policy and continue buying but perhaps to buy even more bonds.  Once you think you've escaped from the bottom falling out, it's going to take a lot more assurance to jump back into the game.

But Bernanke can only play that game for so long without destroying the value of the dollar.  You can't manipulate market for IOUs for dollars and destroy the value of those dollars at the same time.  At least not in the long run.  Eventually he's left with only two choices: Destroy the dollar or let interest rates rise.  The only thing delaying making that choice is the perception by the market, mainly our export partners, that the US will not default on its bonds.

But between now and then, I would expect Bernanke to reverse course on his news conference and say the economy is 'weaker than expected' and will continue their $85B a month purchases of MBSs.  That should settle the markets for a while and entice the speculators back in.

"Come on in....the water's warm!"