Bernanke Shakes up the Markets

Stock and currency investors are probably happy Feb. 29 comes around only once every four years, as the markets were incredibly volatile. Chairman Ben Bernanke addressed Congress yesterday, and sent the stock market into a tailspin by suggesting he has no plans to institute another round of stimulus. Bernanke’s speech sent the dollar higher and gold down almost 5%, a wild leap day for sure!

The morning of the 29th started off fairly calm, with no overnight news out of Europe and the currency markets happily trading in a fairly narrow range. The US markets were encouraged by the release of the fourth-quarter GDP, which showed the US economy grew a revised 3%, up from the previous estimate of 2.8%.

Economists weren’t expecting the increase, and both personal consumption and the GDP price index also came in above expectations. This gave investors some confidence in the global recovery, and had them continuing to shift money into some of the higher-yielding currencies. But Chairman Ben Bernanke changed all of this during his testimony to Congress.

As Chuck pointed out, I have been able to stay out on the desk this week, and Mike Meyer pointed to the trading screens just after 9 a.m. yesterday and let me know I would have plenty to write about today.

The currency screens were lit up like a Vegas Christmas tree, and gold went into an absolute free fall. After watching the action for a while, I went on a hunt to find what had sparked all of the selling, and quickly discovered it was our Fed chairman’s remarks to Congress.

I’m pretty sure our Fed chairman didn’t expect his remarks to have such a dramatic impact on the markets, as he gave a fairly upbeat assessment of the economy during his semiannual testimony. Bernanke said he is seeing “positive developments” in the job market while warning that it is still “far from normal.” He also said the inflationary impact of higher gas prices will likely be temporary.

The speech was more of the same talk we have been hearing for a while now: The US economy is recovering — albeit slower than most would prefer — and the Fed would be keeping interest rates low for an extended period. But then Bernanke dropped what the markets turned into a bombshell by suggesting there is no further need for additional stimulus.

As recently as January, many Fed policymakers were suggesting that another round of QE would be needed. But the chairman quashed thoughts the Fed would be embarking on another round of bond buying, as he suggested the US economy won’t need another round of stimulus.

The stock market was the first to react, as the equity traders have become accustomed to a steady stream of Fed stimulus. But the selling quickly moved over to the currency and precious metals markets, in which investors had a knee-jerk reaction and sold both currency and metals moving back into the shelter of the US dollar.

As I said earlier, I’m sure Ben Bernanke wouldn’t have thought his testimony, which seemed to indicate the US economy is slowly but surely recovering, would send investors running for cover, but that is exactly what happened. Apparently, investors are worried the US economy won’t continue on this nascent recovery without some additional help from the Fed.

The biggest loser in the currency markets yesterday was the high-yielding Brazilian real (BRL), which dropped over 1.25% versus the US dollar. Both the Swiss franc (CHF) and the Swedish krona (SEK) also fell over 1%, and the euro (EUR) dropped 0.99% versus the dollar. The currency markets stabilized by the late afternoon, and overnight investors have taken advantage of the lower prices to move some of their funds back into these currencies.

A report released this morning showed European inflation rose 2.7% in February, slightly higher than January’s 2.6% reading. Unemployment rose to 10.7% in January, a 14-year high, according to a separate report. Europe definitely has a tough road ahead, and who knows what challenges will be added by the credit crisis over the next few months.

As Chuck reported in yesterday’s Pfennig, the ECB let loose another massive round of funding to help shore up European financial institutions — a move they hope will stabilize the credit markets. But mirroring Ben Bernanke’s comments, ECB members are suggesting this will be the last round of LTRO. European leaders will gather in Brussels today for an EU summit (I find it amazing how many summits and emergency meetings the EU leaders seem to hold), and some are expecting them to announce another increase in the size of the bailout fund.

The Italian prime minister has said he is going to push for additional funds, as unemployment in his country increased to 9.2% in January from 8.9% in December. Italian Prime Minister Monti is implementing 20 billion euros of spending cuts and tax increases to trim his nation’s debt, but still feels the EU “backstop” fund needs to be increased. But German Chancellor Angela Merkel, who holds the big hammer in the EU, has said she is not interested in discussing another increase.

There was no dramatic news from Greece last night, and the debt swaps/reductions seem to have stabilized things for now. But the debt deal that was reached with bondholders may have some unintended consequences. Readers of the Pfennig will remember credit default swaps, which caused a lot of anxiety in the US markets during the subprime mortgage crisis. These financial instruments are basically an insurance policy investors purchase in order to protect them from the possibility of a default.

Through negotiations, Greece was able to avoid a default by getting investors to agree to “haircuts” on their debt holdings. Investors swapped their existing bonds for new ones, reducing the amount Greece would have to eventually pay out to these holders. But there is still a question over whether this action by Greece could still be considered a default. Moody’s downgraded Greece earlier this week, suggesting the country was in “structural default,” and now bondholders are pushing for payment on credit default swaps they purchased against Greek debt.

The International Swaps and Derivatives Association (ISDA) will be meeting today to see if the Greek restructuring should be considered a default, and their decision could send shock waves through Wall Street. While the big financial institutions of Wall Street have largely avoided the Greek crisis, many of the CDS contracts insuring against a Greek default have been issued and underwritten by these large US institutions. There is a possibility that these US institutions will end up paying for the “haircuts” agreed to by the holders of Greek debt.

While the currency markets were exciting yesterday, their moves were dwarfed by the dramatic swings in the precious metals markets. Gold lost nearly $100 at one point yesterday, and silver dropped almost $3.38. Both recovered in overnight trading as Asian investors took advantage of these lower prices. The combination of Chairman Bernanke’s comments and the Europeans suggesting they would not be pumping any more liquidity into the markets was the shot that sent both precious metals into the tailspin.

Technical selling accelerated the descent, as both gold and silver moved through support levels during their initial moves lower. I was relieved and encouraged to see the Asian investors moving back into the markets, and both metals are moving higher today. The precious metals continue to be excellent investments. Even after yesterday’s fall, gold is up 9.21% and silver is up an amazing 24.79% in 2012.

The currency markets are recovering this morning also, with the high-yielding currencies leading the way. Good news out of China is helping push investors back into the Australian dollar, New Zealand dollar and South African rand. A report showed China’s manufacturing sector is expanding in February for a third straight month. The Chinese purchasing managers index rose to 51 from 50.5 in January.

Another PMI report released out of India showed that country’s manufacturing index was close to an eight-month high. This is good news for the global economic recovery. We continue to believe the engine of economic growth over the next several years will be located in Far East, with China and India pulling the rest of the global economy up with them.

I read a story this morning that indicates the Chinese central bank is looking to boost the use of the Chinese renminbi (CNY) for cross-border trading. According to the story, which appeared in the Chinese source Xinhua, “China will further boost the use of its currency in cross-border trade and investment settlements in 2012 as it gradually makes the yuan more internationally convertible, the country’s central bank said Wednesday.”

Chuck has pointed out all of the currency swap agreements China has entered into with several different countries trying to increase the use of the renminbi, and the Chinese leadership is definitely increasing their efforts to get their currency more widely traded. “According to earlier data released by the central bank, China’s overall cross-border trade settlement in yuan under the current account hit 2.58 trillion yuan (US$409 billion) by the end of 2011, since the scheme was launched.”

China is also loosening its restrictions on individual investments in the renminbi, allowing institutional investors access to the mainland securities markets. Individual investors have had the ability to invest in the Chinese renminbi at EverBank since before China started to allow their currency to float in 2005.

Then there was this. My friend and new co-worker Jack Stapleton, knowing I was responsible for the Pfennig this morning, sent me a story written by Peter Wadkins that appeared on Thomson Reuters yesterday. The story focuses on the corruption rampant in Greek culture, and quotes a DJN report that cites a recent EU corruption survey that found 98% of Greeks consider corruption a major domestic concern. “A landmark study by the Washington-based Brookings Institution from mid-2010 estimated that corruption costs Greece the equivalent of 8% of gross domestic product each year. The study showed that bribery, patronage and other public corruption deprived the Greek state of more than EUR20 billion each year.” The corruption just adds to the problems faced by Greece, and will definitely make their recovery all the more difficult.

To recap: The markets had a wild “leap day” after Ben Bernanke suggested there won’t be a QE3. European inflation is increasing, and unemployment is also on the rise, which should make the recovery even more difficult. The ISDA will rule today if Greek has defaulted, which could send shock waves across Wall Street. The precious metals dropped dramatically yesterday, but recovered in overnight trading as investors took advantage of the bargains. The Chinese central bank is looking to increase the status of their currency, which won’t surprise any Pfennig reader.

Chris Gaffney
for The Daily Reckoning