Is the Fed Losing Control?

In the past two weeks, we heard from Chairman Hyde and then Chairman Jekyll.  A couple of weeks ago, Ben Bernanke made allusions to gradually winding down the Fed's bond buying program, called quantitative easing.  Up to this point, the market had perceived the current round of QE as infinite, a perception that Fed had encouraged by placing no time limts on the program, and offering only the vaguest of guidance as to when QE might end.

But two weeks ago Chairman Hyde frowned and cleared his throat, and the bond bulls began running.  In their panic, they gored many an investor who had drank the Kool-aid however reluctantly and bought risk assets like long term Treasuries, corporate bonds and junk bonds.

Within days of Chairman Hyde's hint that the punch bowl might be taken away, the ten year Treasury note was yielding over 2.5% (up from 1.6% in May) and 30-year mortgages popped up about 1% to 4.5%.  Stocks quivered, but didn't belly flop like bonds.  Alarmed, various governors of the Fed and presidents of Federal Reserve Banks chimed in and suggested that the punch bowl wouldn't be withdrawn any time soon.  Stocks perked up, but bonds continued to pout and mortgage rates kept rising. This was emphatically not what the Fed wanted, since the Fed is resorting to its old trick of trying to revive the economy by bubbling up the housing market.  Even though this is what got us into trouble in 2007-08 with the mortgage crisis, the Fed evidently has an abiding faith in its old tricks.

With the housing rally now threatened, Chairman Jekyll spoke up this past Wednesday (July 10) and made nice nice.  The little toddler of a recovery would need propping up for a long time, he said, before he'd expect it to walk on its own--a very, very long time.  He also said he was sending the senior Fed staff out for a late night booze run to stoke up the punch bowl.

Stocks did a cheery little conga and stepped up to new heights.  This might produce a bit of a wealth effect to boost the economy.  But it will be hardly a smidgen, if the bond market doldrums continue. Bonds barely budged after Chairman Jekyll's attempted love fest.  The ten-year Treasury dallied briefly with the 2.53% level, but then went back up to 2.59%.  Mortgage rates continue to cloud the skies over the housing market. 

Is the Fed losing control?  This is really two questions.  What message is the Fed trying to send?  The most recent minutes it released indicate sharp divisions within the Open Market Committee, and the truth may be that a highly mixed message would be the most accurate.  Bernanke's initial statements two weeks ago may have been an attempt to be transparent and let the public know what the Committee really thinks.  But the Fed got what it perceived as an over-reaction from the market, and has been trying to cover its tracks ever since.

But did the Fed get an over-reaction, or an accurate reaction?  The sharp sell-off in bonds and rise in mortgage rates may have reflected the erstwhile rationality of betting on a continuing rally in fixed income.  Central banks worldwide have joined together and danced the most accommodative bunny hop in the history of banking.  Anyone who anticipated a reversion to the mean in the money markets has been just about rendered CIA-style. Much of the flash crash in the bond markets may have been hedge funds and other big players unwinding leveraged positions betting on more booze for the punch bowl.  Now that the Open Market Committee may be going wobbly on the idea of giving a drunk yet another pitcher of Martinis, bond pros evidently are becoming wary of the hair of the dog that just bit them.  If so, the Fed may have lost control of the long end of the yield curve.

If the Fed no longer has a clear message to send, and can't maneuver the long end of the yield curve any more, it may lose control of the economic recovery.  But perhaps it never really had that much control.  Maybe things looked good for a while because people wanted to believe, and the Fed provided the only federal economic policy they could believe in.  With Chairman Bernanke now a short timer, courtesy of President Obama, it's unclear what anyone can believe in.  And that won't be good for the market or the economy.