Bernanke's many degrees of easing

Ben Bernanke left no doubt at Jackson Hole that he's willing to dive deeper into unfamiliar policy territory. But investors should take a nuanced approach as assets won't benefit uniformly from Fed action.

FT.com

How should investors react to Ben Bernanke's much-anticipated speech last Friday at the annual Jackson Hole Symposium of central bankers?

Here are key takeaways and, more importantly, what the remarks by the Federal Reserve’s chairman imply for markets going forward.

Perhaps with an eye on protecting his legacy (and responding to political attacks), Bernanke went out of his way to provide a robust defence of the Fed’s unconventional monetary policy.

He did so using historical analyses, some preliminary model results and whatever academic work he could find for what is still "unfamiliar territory”.

Bernanke left no doubt that he is willing to continue to press the policy envelope further out – even while acknowledging that "both the benefits and costs of non-traditional monetary policy are uncertain."

His willingness to use imperfect tools to pursue what have been largely elusive macroeconomic objectives is more than just a function of the "daunting economic challenges” facing the US.

He believes that the domestic headwinds reflect more cyclical structural factors. He rightly worries that the longer they persist, the greater the threat that cyclical problems could become structural in nature.

Echoing the minutes of the last Federal Open Market Committee meeting, Bernanke stressed that he is not looking for just any pick-up in jobs. He is correctly targeting a "sustained improvement in labour conditions”. This suggests that he would keep his foot on the policy accelerator even if employment indicators start to ameliorate.

Bernanke also sees a need to "take out insurance against the realisation of downside risks”. I suspect that this reflects concerns about the US fiscal cliff, Europe's debt crisis and geopolitical instability in the Middle East.

While signalling that both baseline analysis and risk scenarios justify greater policy activism, he stopped short of providing details on the individual measures he favours. Instead, he retained optionality on an open-ended list, also managing to frighten short-sellers who doubt his ability to deliver.

Investors with long market positions cheered the speech. Indeed, every major market segment traded higher in price – from equities to government bonds and from corporate credit to commodities.

It is tempting to attribute this broad price rally to the belief that all financial assets will benefit uniformly from repeated injections of Fed liquidity. But this is where investors should be more nuanced.

Depending on the market segment, there can be significant and variable gaps between what Bernanke is willing to do (a lot, and bolstered by the fact that the Fed is undershooting both components of its dual mandate); what he is able to do (more limited since he is forced to resort to imperfect tools and without the support of other policy making entities); and ultimate effectiveness (even more limited given sluggish policy transmission mechanisms and insufficient global policy co-ordination).

Investors should not fight the Fed when it comes to what this institution, with its printing press, can deliver with a high degree of confidence – namely anchoring the front end of the US Treasury curve (up to the seven-year point as an illustration) and repressing related volatility.

With renewed purchases of securities and its willingness to extend the guidance language into 2015, the Fed can keep these rates artificially low for quite a while.

Long-maturity US Treasuries are a trickier proposition for the Fed. This favours a number of assets, including high quality short- and intermediate-maturity corporate bonds, agency mortgages, related sales of volatility and even some high-quality non-agency mortgages and structured products.

It also supports hard assets, such as gold, where people go in an attempt to protect against the potential risk of higher inflation.

The temptation to extrapolate this argument to other risk markets is tempting. But investors should recognise that the Fed has much less control on prices in the equity and high-yield segments. Similarly, a differentiated analysis is warranted for currency positioning.

Here, fundamentals – whether domestic or international – can overwhelm the impact of Fed action. This is especially true in today’s global economy; one that is in a synchronised slowdown, gripped by an unusual level of political polarisation in Europe and the US and lacking any sustained cross-border policy coordination.

Technicals are also an issue. There are consequential differences among asset classes when it comes to the balance between traders and long-term investors.

Bernanke’s speech should answer most questions on whether he is willing to lead his Fed colleagues deeper into experimental monetary policy. He is.

Yet in extrapolating the market impact, investors would be well advised to differentiate. Particularly in today’s extremely fluid global economy, there can be sudden lapses in some markets when it comes to mapping Bernanke’s willingness to his effectiveness.

Mohamed El-Erian is chief executive and co-chief investment officer of Pimco.

Copyright the Financial Times 2012.