Markets hang on Bernanke's words

WHO would want to be Ben Bernanke at the moment? The US Federal Reserve chairman is en route to Jackson Hole, Wyoming, where he will speak at midnight tonight Australian eastern time. The US sharemarket has surged this week on speculation that Bernanke will step in, wave his magic wand over the US economy and produce another round of quantitative easing. QE3, as it is known, would be likely to involve the Fed buying bonds as a way of pushing down long-term interest rates and encouraging borrowing.

Why the market feels that QE3 is the silver bullet to the economic downturn or that Bernanke will even announce such a plan shows how desperate the hunt for good news is at the moment.

It seems to be operating on the theory that if it is said enough times then maybe it will come true. Either that or those in the market are trying to push up share prices in an effort to cash in on some short-term profits, which have been hard to come by in recent weeks.

Any way you cut it, though, it appears the market has conned itself into believing that it is getting an Xbox for Christmas when there is a second-hand Atari sitting under the tree.

It has done this because Jackson Hole is the venue where Bernanke signalled a $US600 billion Treasuries purchase plan, or QE2, a year ago. Shares rose 28 per cent on that news and the market is nostalgic in thinking that Bernanke can play it again.

However, there are many reasons why history won't be repeating itself.

First, Bernanke would need to persuade the other members of the Fed that QE3 would be an effective shot in the arm for the economy. When he put that argument a year ago, only one board member disagreed. Now, he has three to contend with: the Federal Reserve Bank presidents of Minneapolis, Philadelphia and Dallas, all of whom voted against a measure earlier this month to keep interest rates at near zero until mid-2013. The reason these three are unlikely to support further easing is because it is debatable how effective QE3 would be in spurring borrowing in a market where credit is already so cheap. Yields on bonds are also at historic lows, making you wonder how much encouragement nervous investors need to creep back into riskier investments such as stocks.

Second, there have been no speeches by other Fed members "softening the ground" like last time. The Fed is generally cautious not to say anything to create volatility in the sharemarket so moves such as another round of quantitative easing are usually leaked out before they are announced.

Third, as Deutsche Bank pointed out this week, in Bernanke's congressional testimony last month he said additional policy support would be warranted only if economic weakness continued and deflationary risks re-emerged.

"It is hard to make the case that the latter is occurring in the present environment," Deutsche told clients. "The inflation environment is much less benign compared to conditions at the start of QE2."

Last week's consumer price index figures showed headline inflation was growing (3.6 per cent compared with 3.4 per cent a year ago), as is core inflation (1.8 per cent versus 1.6 per cent a year ago.)

Economists expect QE3 to come, just not while there are few sparks of positive economic news.

While this week's manufacturing data showed the sector continued to weaken, the index of leading economic indicators, which includes things such as stock prices, Treasury yields and jobless claims, was up on the month of June.

It rose 0.5 per cent in July, which followed gains in the previous two months.

Bernanke will also have to brace for the political maelstrom that will erupt if he orders the go-ahead for QE3. Last week, Texas Governor and US presidential candidate Rick Perry said the Fed chairman would be "almost treasonous" if he were to embark on another round of quantitative easing.

"I don't know what y'all would do to him in Iowa, but we would treat him pretty ugly down in Texas," Perry told supporters.

As fellow Age columnist Malcolm Maiden pointed out on Wednesday, sharemarket volatility is likely to continue until it becomes clear whether the US and Europe have managed to stave off a second global recession.

UBS believes Bernanke will try to give some clues as to how he plans to breathe life into the US economy. "The chairman will try to calm financial markets by stressing that the Fed still has tools available to stimulate growth but that he is unlikely to promise their use," the bank said.

If that is the case then it is probably not going to be enough to persuade investors not to drop stocks and scurry back into safer fields such as bonds and gold.

The QE3 speculation has put a retractable floor under share prices this week but expect that to open up and the selloff to be brutal if Bernanke is unable to give comfort about how he can make things better.

The Australian Securities Exchange is likely to be equally skittish on Monday, depending on the size and scale of any selloff of US shares.

The world's eyes will be on Bernanke when he steps towards the lectern to give his Jackson Hole speech. They will be heavy steps, weighed down by an unreasonable expectation that he has the answers to the US economic recovery. Those expecting Bernanke to pull a rabbit out of his hat will be wise to remember that the man is a mere economist, not a magician.