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Today Ben Bernanke surprised the market by giving an incredibly dovish speech to an association of business economists in Virginia. The gist of the speech is that the unemployment rate remains far from normal, long-term unemployment is high as is the under-employment rate. Added to that the Fed is unsure that the current rate of unemployment, which has been declining in recent months, will be sustained.
The pivotal point from Bernanke is that right now the elevated unemployment level is cyclical rather than structural - i.e., caused by weak economic demand - so further accommodation from the central bank could help to ease these problems. He argued that if the US economy is to start producing more jobs then it will require a large ramp- up in production and demand from consumers and businesses, a process that can be supported by continued accommodative policies.
What's in a word?
The use of continued is interesting, since some could argue that the Fed has actually been on a bit of a tightening mission the last few months. The Fed's balance sheet has actually shrunk since peaking in February and has fallen from $2.944 trillion to $2.895 trillion today. This is no small chunk of change. So if the Fed is in continuation mode could the Fed's balance sheet shrink further and Bernanke consider this accommodative?
The Fed's shrinking balance sheet
You could argue yes, since the balance sheet is still over twice the size it was back in mid-2008 when it was less than a trillion dollars in size, so there is a good argument to be made that there is enough stimulus in the economy already. Added to that the Fed's Operation Twist that started back in November 2011, has helped to alter the stock of Treasuries on the Fed's balance sheet - i.e., selling shorter-term rates and buying long-term, to ensure that long-term interest rates stay low for some time. This is a form of easing that doesn't require balance sheet expansion -well, not yet anyway.
The theory is that low long-term rates can help boost the housing market, which remains in the doldrums. We got another dose of bad news from the housing market today after pending home sales fell 0.5% last month and new home sales for February declined 1.6%. It's not that homebuilding is a major contributor to GDP (although it is a good employer) it's that continuing declining home prices in the US is hitting the household wealth effect and could constrain household consumption going forward.
Combine that with a jobs recovery that is nowhere near back its pre-recession peak and the Fed has a problem. The issue for the Fed is that wage growth remains stagnant in the US and that the jobs being created are largely in low paying sectors of the service industry that don't offer benefits, which is another constraint on consumption.
Helicopter Ben to the rescue?
So what does this mean for the markets? We know from the last two years that QE Is music to the markets' ears and liquidity goes down a treat with stocks and commodities.
In the past the markets have tended to react more to the signal of further QE than the actual event itself - with the dollar falling and gold, stocks and commodities all rising sharply. Taking the dollar index as an example, it fell 11% after Ben Bernanke said that the Fed could provide more stimulus if necessary at the Jackson Hole conference in August 2010. QE2 was enacted in November of that year when the dollar actually rose on the immediate announcement as you can see in the chart below.
PLEASE NOTE THIS IS A BLOOMBERG CHART AND FOREX.COM DOES NOT OFFER THE DOLLAR INDEX AS A PRODUCT.
So can gold and stocks repeat their QE performances? Gold has been in the doldrums, I like to think it is a very misunderstood asset (I don't think I fully understand it or its appeal, apart from to wear it of course), so hence this store of value has massively under-performed during the sovereign debt crisis. In fact it only seems to rally when there is excess liquidity in the system and the money has nowhere else to go. On the back of Bernanke's comments gold surged a cool $25 on Monday.
It is currently testing a cluster of daily SMA's and today's move has totally changed the near to medium-term outlook for gold. It opens the way to clearing the $1,700 hurdle in the coming days, and may then target $1,800 highs.
However, conditions are different than they were back in 2010 and inflation is much higher. Brent oil is already above $125 per barrel, and if it goes any higher - combined with the effect of more QE on the oil price - and we could have a major inflation bubble on our hands. The Fed will be only too aware of this, and going forward it has to negotiate a tricky path to meet its inflation/ jobs mandate that could include curve balls from Iran and Europe's sovereign debt crisis.
It's all about continuation:
Thus, we come back to the continuation word - the Fed may not actually extend its balance sheet and this could limit how much extra liquidity is out there and how much Fed action can pump up asset markets. Unless, that is, we see another summer economic malaise and a creep higher in the unemployment rate. If that happens then the Fed has clearly signalled today that there is more accommodation to come, which may account for some of the upward thrust in asset markets on the back of Bernanke's speech.
So regarding the gold price, we may re-test $1,800 highs, but anything further may not be possible if the Fed is concerned about inflation and chooses to continue with its Operation Twist past the June 2012 expiry.
Gold Daily: a different type of QE could mean that gains are capped if the Fed doesn't extend its balance sheet. Hence, although gold has risen sharply today it remains well below its $1,900 peak from last summer.
Source: Forex Charts
SPX 500 Daily: The Fed comments caused US stocks to rise sharply and the uptrend remains intact. Added to that, the daily RSI isn't pointing to overbought conditions so there could be further to run in this. But on a shorter-term basis, the $1,420-50 level could be fairly sticky as the markets digest just what it is that Bernanke meant on Monday and, crucially, how close his finger is to the printing press on button.
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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