Saying Goodbye to the Bernanke Put

By Vince Foster  OCT 30, 2012 2:05 PM

If there has been one constant in the Bernanke Put, it has been a reduction in volatility. However, if he loses control, that Put will be worthless.


Last week fin Charting a Course Balancing Open-Ended QE and the QE Asset Reflation Correlation Trade, my goal was to provide a map for the markets into year end.  The strategy was predicated on the notion that flow and not discount was driving price action and therefore the technical landscape would provide the best navigational tool for investors. Despite what many assume to be market-moving events such as the FOMC meeting and upcoming month end, mutual fund year end, employment, and the election I cited important technical levels that I thought would get tested regardless of the outcomes.

Regarding stocks:

Friday ES closed at 1424, not far above the level that brought hedge funds to cover.  Next week we should at a minimum expect the market to test the area between 1425 and 1400.  For the rally to stay in tact hedge funds will have to defend this area.  If 1400 gives, the main buyers will then be under water and presumably turn sellers, putting a lot of pressure on the market.  If 1400 holds, you should expect an attempt to rally the stock market to new highs possibly into month end and into year end.

Regarding bonds:

In terms of the bond market I do not want to assume that what’s bad for stocks is good for bonds and vice versa.  As I have repeatedly said the 150-00 level on the US bond contract is real and must be respected regardless.  After Friday’s rally the US bond contract is entering intermediate resistance at both price and momentum between Friday’s closing level up to 148-00.  With the Fed on deck Tuesday and with stocks poised to test lower levels, investors should expect the market to challenge this area.  Nevertheless bond market price action needs to be interpreted independently of stocks market price action.

The main thing I missed was stating that the FOMC meeting was on Tuesday instead of on Wednesday.  Other than that the markets behaved exactly according to plan.  This is evidence that my thesis on the market trading off of flow rather than discount is correct.

Out of the gate on Monday the stock market was under pressure and on Tuesday sold off hard with ES trading down 20 handles to the 1405 level.  After chopping sideways on Wednesday and Thursday the Apple (NASDAQ:AAPL) earnings miss and lowered guidance saw ES flush the aforementioned 1400 level after hours before recovering to close Friday at 1407.50.

Was that enough to hold 1400?  It’s too early to tell but I have a feeling that in the next two weeks we will have the answer.

The US bond contract responded to resistance as well, trading right up to the 148-00 on Tuesday before backing off hard on Wednesday down to find 146-08 support early Thursday.  The volatility was intense and led by the belly of the curve, the bond contract reversed late Thursday into Friday rallying back to close the week at the 148-00 level on the dot.  This was a textbook kiss back of the underside of the previous week’s breakdown.

Is 148-00 now resistance like 150-00 before it?  Again it’s too early, but like stocks, the coming weeks will be crucial.

This idea that flow and not discount is dominating price action is a direct product of Chairman Bernanke’s uber-easy and overly manipulative monetary policy.  As I wrote back in June in Trading the Wrong Playbook Bubble, the Fed has removed fundamentals from the equation.

With Ben Bernanke having turned all assets into commodities, market price is not driven by valuation and growth based on models and forecasts, it’s driven by positioning and sentiment based on speculation and fear.

This commoditization of all asset markets works when prices behave as the Fed intends, but as I warned last week, this apparent benefit comes with increased risks.

The Fed could potentially be a victim of their own success.  By being so egregious in their attempt to manipulate the market pricing mechanism and by also boasting about it they have put themselves in a box.  If and when the market doesn’t behave the way investors think it should, at least when the Fed is inflating, investors will start to lose faith that the Fed is in control.

Last week two prominent investors echoed this heightened risk factor in letters to their respective investors. In the letter dated October 23, David Einhorn of Greenlight Capital warned about excessive QE and money printing and the risk of what happens when the market turns against them.  Via Dealbreaker:

This buying binge brings to mind American Express (NYSE:AXP) cards, which are famous for their promise of no pre-set spending limits.  But as some AmEx customers have learned, there is a spending limit – they just don’t tell you what it is.  AmEx anticipates how much you can repay based on your annual income and your payment history.  When your charges exceed their estimates, they cut you off until you pay off your balance.

Central bankers should keep this dynamic in mind, as they continue to run their printing presses.  While the ink may be endless, the market’s tolerance is not (though there is no sign that it is nearly exhausted).  Like American Express, the market won’t let the central bankers know what their spending limits are until they have exceeded them and get cut off.

The following day in a letter dated October 24, Axel Merk and Yuan Fang of Merk Funds wrote about the election outcome and pending policy conundrum and potentially lose-lose situation facing the Fed.

On the one side, should economic data continue to surprise to the upside, it will be increasingly difficult for the Fed to carry on its dovish policies. On the other side, if the Fed were to abandon its current commitment, we foresee rising market volatility. The US economy is likely to face a “monetary policy cliff” in addition to the “fiscal cliff.” With easy money, inflation risks may well continue to rise, possibly imposing higher bond yields (lower bond prices) and a weaker dollar. With tight money, the Fed may induce a bond selloff.

That sounds a lot like the risk of a monetary debacle that I cited last week.  In my view the perceived ineffectiveness of the Fed’s ability to backstop asset prices is the main risk facing financial markets.  Not a recession.  The problem is not only is this risk underestimated by market participants, it’s also unquantifiable.  And there is no precedent.  Not too mention, as Einhorn implies, if this it hits the market, it will likely be after it’s too late to reverse.

That’s the bad news.  The good news is that the market price action is providing investors with definitive lines in the sand for which to determine when this risk is becomes elevated.

The next two weeks are critical.  With Hurricane Sandy potentially shutting down the transportation networks in the Northeast, trading desks could be lightly staffed as funds try to wrap up month and year ends.  Friday we get the October employment data and the following Tuesday is the election. 

If 1400 on the S&P (INDEXSP:.INX) holds, odds are hight that stock prices will rally to new highs into the end of the year.  If 1400 gives, odds are high that equity positions will get rapidly (and potentially violently) de-risked.  Large speculators entered last week’s sell-off considerably less long than the previous week, and that is probably why 1400 survived the post AAPL flush.  But make no mistake about it: If the market takes out 1400 over the next two weeks, it will be Katy bar the door as hedge funds that have been the main bid since summer will be looking to get liquid before year end.

In the bond market I keep harping on the 150-00 pivot in the US bond contract.  After last week’s price action now we also have 148-00.  Friday the market closed near short term overbought territory so it should be tough to see a challenge of 150-00 from these levels.  You might need a bit lower to gather the energy needed to take on this monumental pivot that has confined the bond market since the first of June.

I will be looking to see how the market trades next Friday’s employment report and into the election.  Another failure at 150-00 that slices through 148-00 would potentially be very bearish.  However if after the election the US bond contract is above 150-00, it sets up for a rally to new highs into year end.

As I stated last week, contrary to conventional thinking, the equity and bond markets need to be interpreted individually.  It's flow, not discount, that is driving price action, therefore investors need to be careful about getting trapped into drawing any fundamental conclusions from market prices.  Furthermore, the main risk in this market is not fundamental.  The main risk is a violent unwinding of speculative positions that are predicated on the Fed’s ability to reflate assets via QE.  

The previous two unwinds occurred in 2010 and 2011 after the Fed walked away.  If we get something akin to either of those moves in the coming months it will be as if the Fed is still active in the market.  So during the next QE unwind it will seem as if the Fed is no longer able to affect asset prices.  If there has been one constant in the Bernanke Put, it has been a reduction in volatility, however, if he loses control, that put will be worthless.  That will no doubt see a spike in implied volatility premiums which will correspond to a significant widening of risk premiums, threatening all leveraged positions and wreaking havoc across financial markets.

Twitter: @exantefactor
No positions in stocks mentioned.