Backbone Not Likely in Fed’s Exit Strategy Toolkit

Good Evening: Just when market participants had grown used to the stock market’s recent pattern of falling in the morning and rising in the afternoon, U.S. share prices pulled a George Costanza and did the opposite today (if you are unsure what this “Seinfeld” reference means, click here). Higher markets overseas, some decent earnings reports, and a positive interpretation of the jobless claims figures were all factors in pushing stocks to new highs for the year this morning. Some profit taking left the market looking a little winded in the afternoon, but it was a good day for the bulls nonetheless. Perhaps a few more sessions like today will cause the Fed to start thinking about implementing the “exit strategy” Ben Bernanke offered Congress earlier this month, but, to turn a cliché on its head, for every way there must first be a will.

Stocks in Asia and Europe were green enough this morning to propel our stock index futures higher. Positive earnings reports from MasterCard, Visa, Cigna, and Motorola only added to the anticipation prior to this morning’s open, even if Exxon and Symantec missed. Initial jobless claims scooted higher during the latest reporting week, but analysts (like those at BAC-MER, see below) pointed to the third consecutive drop in continuing claims as a reason to keep thinking the recession is over. Distortions caused by mis-timed seasonal factors this year, as well as the increasing number of those who are rolling off the continuing claims report because their benefits have expired, were brushed aside. The data point to “fewer layoffs at hand”, says Bank of America/Merrill Lynch. We’ll find out soon enough with next week’s non farm payrolls numbers, for which the early guesstimates are centering on 300K to 350K.

As if hearing Cramer’s soundboard shouting “buy, buy, buy!”, investors bid up stock prices as soon as the opening bell rang in New York. Within sixty minutes of trading, the major averages were sporting nifty gains of 2% or more. Twenty minutes and another 0.5% later, the highs of the day were in. Peaking at just over 996, the S&P 500 just missed out in its first attempt to surmount the 1000 level since just after Lehman Brothers went the way of the Dodo bird. Roaring back due to a fierce rally in commodity prices, the energy and materials names that were so weak on Tuesday and Wednesday were the leaders today. After trading sideways for the next few hours, the indexes were hit by some profit taking during the final hour. Though half the day’s best levels, the closing gains were still notable, ranging from the Dow’s 0.9% to the Dow Transport’s 1.8%. It’s far too soon to say if the pattern change away from morning weakness and afternoon strength means a trend change is at hand, but it will bear watching.

Like the 7 year note auction, Treasurys fared better today. With the 7’s receiving more numerous and higher quality bids (read: foreign central banks) than at any auction this week, the rest of the curve benefited — if unevenly. Yields on shorter dated maturities fell only a couple of basis points, while those at the long end fell as much as 10 bps. The yield curve’s penchant for flattening this week persisted today. The dollar fell with the renewed level of risk taking, and commodity market participants took full advantage. Crude oil regained most of what it lost yesterday, and the grain markets behaved as if no rain will fall between now and Labor Day. Posting a gain that approached 4%, the CRB index was the site of the real action today.

Elevated stock prices and buoyant commodities prices have been an unspoken goal of Fed policy ever since the GSEs jumped into the waiting arms of Hank Paulson a year ago. Already then operating at a feverish pace to plug the growing holes in the financial system, the Bank of Bernanke hit the panic button in September when LEH failed. Ten months later, the system is limping along well enough that exit strategies are up for discussion, if not action. No doubt Mr. Bernanke would prefer robust economic activity to the increased levels of speculation so evident this morning, but the Chairman will probably take what he can get until economic activity picks up. Come that happy day, promises Mr. Bernanke, the Fed will use numerous and considerable tools to withdraw the massive stimuli now in the financial system.

This “we put it in and we’ll take it back out” pledge is easier said than done, according to FT columnist, Wolfgang Munchau (see below). Mr. Munchau doesn’t doubt the Fed, ECB, and other central banks have “a toolkit of policies to prevent an increase in inflation once the economy starts to recover…but simply possessing such tools does not make an exit strategy.” He cites, among other obstacles, the politics that will complicate the timing of any move to remove bank reserves. When unemployment push comes to inflation shove, voters and the politicians they elect tend to emphasize the growthy half of the Fed’s dual mandate of full employment and price stability. President Obama wasn’t swept into office with a mandate for price stability.

Once growth finally does return, the real risk won’t be that the FOMC doesn’t have the tools with which to fight an incipient inflation, but whether or not they have the will to use them. Perhaps Bernanke believes that just talking about an exit strategy will forestall the need to implement one by keeping inflation expectations in check. But talk is cheap, as Hank Paulson discovered when the markets called his Bazooka bluff a year ago. Mr. Bernanke had better hope there is a backbone in the toolkit he showed Congress earlier this month. If the 4% rally we saw today in the CRB some day becomes a habit, he’ll need a Volcker-sized one.

— Jack McHugh

U.S. Stocks Rally, S&P 500 Nears Nine-Month High, on Earnings
Initial claims rise, but fewer layoffs at hand
There is no easy way out for central banks

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