The Exchange

Were Financial Markets Misled by the Fed Minutes?

The Exchange

By Terry Connelly

In the hours following the February 20 release of the Federal Reserve’s Open Market Committee January 2013 meeting, US equity markets dropped over one percent reversing a steady upward climb that had persisted since the swerve around the "Fiscal Cliff" at the start of the year (except for a brief flutter down in early January when the minutes of their previous meeting in December were released).

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What is it about Fed minutes that give “commentators” (many of whom are notorious short sellers) ammunition to talk down the markets so they can shake stocks out of weak hands and then buy them cheaper? In this case, it was the “revelation” that there were voices on the Fed that had doubts about the cost-benefits of the Quantitative Easing program of $85 billion per month government debt and mortgage bond purchases that the Central Bank has undertaken to stimulate extension of cheap credit to businesses and householders and thereby encourage hiring.

Given that the Fed’s QE program is both unconventional and unprecedented, no one should have been surprised by the lack of unanimity among the Fed’s regional presidents and board of governor: Certainly no one who had read the published minutes of the previous Fed meeting in December, where similar voices were recorded. But no one should have forgotten that at both the past two meetings, the Fed has pressed ahead with the QE program (initiated last September despite the pressures of the high political season), with no changes.

Despite the qualms shown by “a number” or “several,” the final vote was decisive (indeed, with only one dissent most recently). Yet the “commentators” suggested that those same minutes meant that the Fed was about to change course and reduce its easy money policies (either “prematurely” or “at high time,” depending on the commentator’s point of view)!

Moreover, few of those commentators paid close enough attention to whether the reported qualms about QE were expressed by “participants” in the meeting – which refers to the whole group around the table, whether or not they are current voting members of the Open Market Committee (which for example only includes five of the twelve regional bank presidents each year, on a rotating basis) or actual “members” of the Committee. A close reading of the comments referencing this distinction could shows that the most recent minutes are actually more dovish overall than in December – just the opposite of what the stock market was led to conclude. Qualms of non-voters would be just that – qualms – not decisive “turn signals.”

Change Is Unlikely

This is not to suggest that there are not real and persistent divisions on the Fed about whether QE is more trouble than it is worth, or that the argument in that direction is without merit. But it is wise to remember that the current Fed Chairman has never embraced his predecessor Greenspan’s passion for opacity and at least nominal unanimity.

Bernanke was chair of an economics faculty: as a dean emeritus myself, I can suggest that deans and chairs learn very early not to expect unanimity or even consensus on their faculties, but merely room to make decisions that faculties themselves often are loath to make. Faculties like to be heard and like to be sure the dean or chair gives them room to express their views and doesn’t get out ahead of them in terms of that opportunity. Bernanke has been meticulous in following that pattern in his Fed Chairmanship. The market needs to finally understand that this Chair can live with even public dissent if he has enough support to “work his will” (as Bob Woodward might say if he chose to write about the Fed Chair rather than the Oval Office occupant). And Bernanke’s will is to continue his QE program until there is evidence of substantial improvement in the outlook for employment (you can find some of his very own phrases in the minutes, too).

The Chairman is highly unlikely to change course and sacrifice his legacy in his last year in office to bend to the views of the bank president from Kansas City or Dallas; it’s not their legacy, yet, nor is it likely to be. And Obama is likely to appoint either Vice Chair Janet Yellen or someone with her outlook as Bernanke’s successor, and she often foreshadows Bernanke’s leadership direction in her public comments – in fact, her speeches between meetings are consistently better clues to the Fed’s direction than the minutes of past meetings. And she has come down clearly in favor of continued easing until the Bernanke target is met.

Expect QE to Continue

The Chairman himself unambiguously (and predictably) reaffirmed the Fed’s commitment to continue QE until the employment outlook substantially improves in his semi-annual report to Congress on February 26. After the minutes were published, Jim Bullard, St. Louis Fed president and noted “centrist” in terms of the Committee’s “hawk/dove” divide, had affirmed on CNBC that the Fed would stay “easy” for a long time forward, clearly foretelling the posture Bernanke took just a few days later.

The notion that the minutes instead foretold a change in Fed policy should have also failed a simple test of policy logic in light of the budgetary showdown on Capital Hill, which right now seems heading for a round of fiscal policy tightening with the Sequester, government shutdown and deferred “debt ceiling” renewal all coming up between March and May. In the face of what looks to be a default by Congress to a policy of fiscal austerity well before we have economic recovery, it would seem that the Fed would in no way take such an occasion to change course away from monetary accommodation that had just been approved by an 11-1 majority in favor of Bernanke’s course.

Chairman Bernanke has repeatedly made clear that he takes the Fed’s employment mandate as seriously as its monetary stability mandate, and the Sequester alone is a likely job killer – not to mention a government shutdown and any renewed debt ceiling crisis. By the time the Fed reviews its bond-buying program at its mid-March two-day meeting, the markets may come to view the Fed as the only sane institution left in Washington.

Why the Rally?

So with recent Fed history, Bernanke’s public commitments, policy logic and the simple mathematics of the Chairman’ overwhelming working majority of voting Fed members, why did the markets think the minutes signaled that the Fed was losing faith in (and about to change) its QE policy so wrong – as evidenced by the huge market rally right after Bernanke clearly shot down that interpretation before Congress?

Well, consider what happened to the stock of Home Depot (HD), a Dow component due to report earnings the day after Bernanke’s scheduled testimony – earnings that were widely expected to be stellar in the wake of a reviving housing market. Before the minutes were released, Home Depot was trading at about 65; after the minutes were released and interpreted negatively, HD dropped back with the rest of the Dow to around 63. Then when Bernanke spoke and Home Depot’s results were announced for the previous quarter, it shot back up to 67, over a five percent gain.

If you were a hedge fund manager who missed the January stock rally (like many of them), the chance to buy HD at 63 ahead of earnings was a big deal. A 4-point gain might not sound like much, but if you bought 100,000 shares for $6.3 million and then cashed out less than a week later at more than a five percent gain, you would have netted a $400,000 capital gain – short-term, of course, but that doesn’t matter if you are a hedge fund domiciled for tax purposes in the Cayman Islands (like many of them). That’s a 260 percent annualized return! Not a bad week’s work, all thanks to those helpful “commentators” who read the Fed’s month-old tea leaves as foretelling a policy change that would be highly negative to stocks!

Once and for all, investors need to understand that folks who find reasons mysteriously hidden in Fed minutes to talk down the stock market are no more inherently credible than the folks who find cause to talk it up. And appreciate that some of the Cassandras may be invested in a bet that you will take their doom-saying seriously. Do your own thinking – this one should have been seen as an obvious head-fake. Fool us once, your fault – fool us twice, ours.

Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education.

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