Bernanke's market honeymoon is over

By Julian Delasantellis

You hear them all the time next door. The loud, angry and obscene language. The sound of flying plates, pots and pans striking the cabinets and the floor. Doors slamming. Somebody getting in the car and speeding off. You know what that means - it’s the unmistakable sound of those volatile neighbors bickering again.

Tuesday saw another 300-point decline in the US Dow Jones Industrial Average. You know what that means. It’s the US Federal Reserve and the US financial markets bickering again.

For the fourth time since August 17, the US Federal Reserve Board has sliced short-term interest rates, part of the continuing effort to counter the negative economic effects of the subprime mortgage crisis. Tuesday’s move involved twin 25 basis point cuts in both the Federal Funds Target Rate, to 4.25%, and the Federal Funds Discount Rate, to 4.75%.

Yes, it seems like the honeymoon sure is over for the Fed and the markets. The markets were thrilled with the first easing move in this cycle, the 50-point cut in the discount rate on August 17. That sparked a 230-point rise in the Dow for that day, a 550-point rise for the following month. The surprise twin 50-point cuts in both the target and discount rates on September 18 were even more appreciated, driving the markets to all-time highs over 14,000 in early October.

The markets and the Fed were getting along swimmingly around then. The relationship was very clear and well defined; the markets, as interpreted by the implied cut probabilities of the Chicago Board of Trade’s Federal Funds futures contract, asked for cuts in interest rates, and the Fed gave them. The equity markets rose, Federal Reserve chairman Bernanke started to receive a bit of the economic savant accolade that former chairman Alan Greenspan had so long reveled in, and everybody seemed happy.

Then, as so frequently happens, one partner in the relationship changed. The Fed, as people used to say in the pre-feminist era, decided that it wanted to wear the pants in the family. In the days prior to the next Fed meeting on October 31, the Financial Times reported that some Fed board members were chafing under the apron strings of the financial markets that they wanted to be able to decide on the appropriate levels of short-term interest rates independent of the market’s dictates. (See my November 2 Asia Times Online article, Bernanke: Don't take me for granted, boys.')

The Fed did deliver another dual interest rate cut on October 31, but by then the markets were not looking at what the Fed was giving it but what it said it was going to give in the future. The markets read the statement that followed the meeting, and interpreted it to mean that they could expect few, if any, more interest rate cuts in the immediate future.

The markets also didn’t like Bernanke’s speech to the Cato Institute in Washington on November 14, in which he elaborated on a new framework for deciding whether to cut interest rates that seemed to severely limit the role of the markets in Fed decisionmaking. (See my November 17 article, Playing 'chicken' with the markets.) That, along with various early November statements from Fed officials proclaiming that, at least for now, the rate cuts were over, meant that the Fed had lots of explaining to do to the markets when it came home in mid-November.

''I’ll show him who’s boss,'' the markets fumed. From November 1 through 26, the Dow Jones Industrial Average lost 1,300 points, about 9% of its value; it was the worst month in the markets since 2002. By late November, the Fed was once again cooing and wooing the markets with the very sweet romantic affirmations that it knew they loved to hear - that it was willing to start the interest rate easing cycle once again. From late November to this Monday the Dow threw in an impressive, 1,100 point, 8.6% rally, to 13,800.

But, as Tuesday’s selloff proved, the markets wanted something more than what they found when the wrapping was removed from the Fed’s latest present. Evidently, they had wanted twin 50-point cuts, or at least a 25-point cut in the Federal Funds Target rate along with a 50-point cut in the discount rate. There was also probably not a lot of appreciation for the line in the Fed’s post-meeting statement that ''elevated energy and commodity prices, among other factors, may put upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.''

In other words, I hope you like your present, Mrs Dow Jones. Don’t expect much more anytime soon.

The next move is up to the markets. If the selloff continues and accelerates back to the mid-August/late November lows in the mid 12,000s or lower, then the Fed will certainly cut again, maybe even before its next regularly scheduled meeting on January 31. However, if the selloff does not continue, or if the rally resumes, then Bernanke’s big gamble may just pay off. He may be able to accomplish something Alan Greenspan never could - that is, retake the policy initiative (grab back the pants) from the markets.
Whatever happens next, the Tuesday selloff proves just how fragile and illusory the surface normalcy that seems to have returned to the markets really is. Before the selloff, the Dow was only 470 points, one really good day, from the all-time highs of early October. Now, it seems that the entire market rebound from the summer panic lows was built on the presupposition that the Fed would cut, cut and cut again, with the speed, and in the quantity, that the market desires, and not one basis point less.

Tonight, I know I will sleep fitfully. I will awaken repeatedly through the night, rolling over and checking Bloomberg TV to see whether the Wall Street selloff has spread to the Asian and European equity markets. For those of us in the financial markets neighborhood, the fighting between the Fed and the markets actually is keeping us up all night.

Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.