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Saying Goodbye to the Bernanke Put


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.

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.
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