Does Ben Bernanke even know what he is doing? I've certainly wondered about that point, and it is increasingly a topic of conversation among stock market analysts who have come to understand that all the major US stock market indexes are pushing relentlessly upward because of the Bernanke put.
There hasn't been a significant correction in the stock market since early September, when the S&P 500 left the 1040 range to its present very lofty height of 1330. This rally has set a number of records, including days when the stock market moves less than 1%, and number of stocks above their 200 day moving average. While some analysts credit this advance to improving economic conditions, most observers point to the Fed's deliberate policy to keep the stock market "higher than it would otherwise be", fueling it with hundreds of billions of dollars from the quantitative easing program.
The other evidence in favor of the Bernanke put argument is that volume has fallen off dramatically at each daily advance. This past week volume has been at its low for the year, 40% off even the median volume for the market. This is never the sign of a healthy market, especially one that advances with no corrections in sight. It says investors don't trust the advance, but are unwilling to sell or even take their profits because the direction is so clear for the short term.
The Fed, in other words, owns the stock market for the first time ever. The Fed has assumed responsibility for its move up, promises to protect investors should the market hint at going down, and will take the blame if the Fed is unable to prevent a sell off. Whether the Fed agrees to this is not relevant - this is market perception held by millions of investors. The Fed may not really be to blame when the market finally corrects (and not if, by the way), but the Fed is to blame for this perception continuing.
Given this, many analysts are concluding that Ben Bernanke doesn't know what he is doing. He has no practical experience in the markets, and all of his other fellow-governors at the Fed are economists as he is. The last remaining governor with real-world experience in the markets was Kevin Warsh, and he quit last week with little explanation. Did he realize the Fed is heading for a devastating indictment of market manipulation that will lead to losses for millions of investors?
I've been wondering if there isn't an alternative explanation - somewhat less plausible than the "Ben Bernanke is out of his depth" argument, but certainly not out of the question. It assumes Bernanke is a smart man, an ex-professor of economics at Princeton and someone who has been around the Fed for years. He therefore knows what he is doing and what risks he is taking, and this talk of goosing the stock market is really a fig leaf for the real program.
A Battle with China
Under this theory, the Fed, the Treasury, and the administration are in a battle with China to force that government to abandon its mercantile policies. The US government wants China to significantly revalue the yuan to the dollar, stop subsidizing domestic producers, start opening up its markets to US companies, and cease stealing intellectual property.
China refuses to comply, so the Fed introduces Quantitative Easing 1, which weakens the dollar on the exchange markets and starts to stir up a little commodity inflation as well. This pressures China where it hurts: the country is resource poor and has desperate need for cheap commodities to keep its growth machine going. China retaliates by ceasing its purchases of US Treasuries, which is where it has parked its massive foreign exchange surpluses in the past. This puts upward pressure on US long term interest rates, so the Fed introduces QE2, which has several benefits for the US. First, it counteracts the interest rate pressure caused by the sudden absence of China as a major buyer of Treasuries. It keeps the dollar suppressed on the exchange markets. It also ignites a more serious commodity inflation boom that now imperils the entire Chinese economy.
Knowing in advance that QE2 will levitate the stock market, which happened in QE1, the Fed makes a virtue out of necessity and uses this inevitable levitation as a major reason why QE2 is needed. In fact, the Fed has no problem using this cover story, because there has been a demonstrable uptick in consumer spending based on the stock market "wealth effect." The uptick has taken place in luxury goods and is limited to the wealthy, but it is there nonetheless, as justification for QE2.
The Fed can point to this success, knowing however that it now has a problem deflating the stock market when QE2 ends, assuming no QE3 is needed. Unfortunately it may well be needed; China still is obdurate about revaluing the yuan, and it has not reversed its policy to limit its purchases of Treasuries. The Fed has now surpassed China as a significant owner of Treasuries, and will likely keep on this path as long as China does not buckle to the pressure.
The Market's Fate is Sealed
If this theory is correct, the stock market's fate is sealed one way or the other, at least in the short and intermediate term looking out six months or more. If China concedes defeat, QE3 will not be needed and the stock market will react to this disappointment. If QE3 is needed, and the economy is booming, everyone will be puzzled as to what is really going on, and theories such as this one will come to the fore. The stock market will be disappointed to discover it was duped and its rally was based on false premises. If QE3 is needed, and the economy is sinking back into recession, The Fed and QE2 will be blamed because the commodity inflation that was instigated is now attacking US consumers as well as Chinese (and Egyptian) consumers as well. The stock market will be disappointed that quantitative easing is continuing and will likely make the recession deeper than expected.
The Fed has set a trap for itself, or at least for the stock market, but if the stock market corrects 10% to 20%, the Fed will just go back to its normal stance, which is that it can only really effect short term interest rates, and nothing else. It will be an admission of failure that will require some political containment, but it ought to allow the Fed to keep its franchise. If the stock market crashes, which is not out of the question given that it is dominated by computer programs that don't care whether the Fed survives or not, all bets are off for the economy as well as the Fed.
This is all theorizing and speculating as to what is going on with the Fed, because the times we live in, and the Fed's policy approach, are so out of ordinary experience that it is as if everyone is flying blind. The one thing we can all agree on is that these are perilous paths being traveled by governments and markets alike, and avoiding disaster is getting harder and harder.
First published at The Agonist