Federal Reserve Chairman Ben Bernanke's speech this morning didn't completely eliminate the elements of risk aversion lingering in the financial markets, as the US dollar and Japanese yen both remain strong. However, the currencies haven't rallied further either, suggesting that Mr. Bernanke's slight optimism on the outlook for the financial markets could lead the safe haven dollar and Japanese yen to pull back in the near term.
The first portion of the speech discussed the history of the financial crisis, noting that while issues in the US subprime mortgage market triggered the collapse, it was only a small portion of the massive increase in credit expansion, which was accompanied by widespread declines in underwriting standards, breakdowns in lending oversight by investors and rating agencies, increased reliance on complex and opaque credit instruments that proved fragile under stress, and unusually low compensation for risk-taking. Mr. Bernanke went on to say that the timing and strength of any recovery in the global economy is highly uncertain, but that policy responses by the world's governments will be critical determinants of the speed and vigor of the recovery.
The second portion of the speech focused on the Federal Reserve's own policy responses, and Mr. Bernanke noted that while interest rates were extremely low, they were not without other options as policy communications were still an effective tool. This is indeed true, as the markets listen carefully for any sort of bias issued by the central bank and price any shift in long-term interest rate outlooks into various assets, such as the US dollar and Treasuries. Furthermore, Mr. Bernanke explained their efforts to boost liquidity in the markets, and made a point of saying that fear of lending was still a problem. Methods by which the Federal Reserve hopes to deal with this include the introduction of facilities to buy highly rated commercial paper, along with a joint effort with the Treasury to force banks to lend, as they will provide three-year term loans to investors against AAA-rated securities backed by recently originated consumer and small-business loans. Mr. Bernanke also hinted that if this asset-backed securities facility proves to be successful, its framework may be used to support other classes of securities and higher volumes.
The third portion of the speech talked about the differences between the Federal Reserve's credit easing efforts and the Bank of Japan's quantitative easing efforts between March 2001 and March 2006, which have been judged as being generally unsuccessful.
Finally, Mr. Bernanke said that if President-elect Barack Obama does indeed implement a large fiscal stimulus package, it is likely to provide a significant boost for the economy, but in order to promote a long-lasting recovery the plan must include measures to further stabilize and strengthen the financial system. Additional assistance may be needed in the form of more capital injections, guarantees, and efforts to remove toxic assets off the books of financial institutions, which happens to be the original intention for the Troubled Asset Relief Program (TARP). Of course, such efforts will not be readily accepted by the public, and Mr. Bernanke urged politicians to convince their constituencies that financial stabilization is necessary for economic recovery.
US Dollar Response
The US dollar has been gaining in recent days amidst a pickup in risk aversion, which has likewise benefited the Japanese yen while hurting the commodity dollars and other risky assets. However, Mr. Bernanke's optimism that the efforts put forth by the Federal Reserve, Treasury, and US government may be planting the seeds of recovery may help to boost investor sentiment a bit. This should translate into a bout of weakness for the US dollar, which has already run into resistance (see chart below), and Japanese yen while boding well for the stock markets in the near-term.