Markets Await Bernanke’s Historic Moment ?

Federal Reserve Chairman Ben Bernanke chose a dramatic time to hold his first post-FOMC meeting press conference. Market watchers are desperate to know if the central bank’s latest round of quantitative easing, the bond buying program dubbed QE2, will be wrapped up June 30 as planned and whether another round of stimulus will follow in its wake.

Meanwhile, questions on inflation, the weakness of the U.S. dollar and the reliability of American debt are also swirling.

The press conference, scheduled for 2:15 PM ET following the release of the FOMC statement at 12:30 PM, is the first of its kind by a Fed chief, though it is common practice for other central banks including the ECB. While a smooth press conference and an FOMC statement in line with expectations would probably lead to a muted market reaction, other, much more eventful outcomes are a possible.  Markets expect a very gradual move of the policy pendulum, from extreme dovishness towards a more moderate, slightly hawkish stance, as Bernanke sets the stage for the end of the Fed’s accommodative policies. That doesn’t mean an immediate about face toward tighter monetary policy though, as rates are expected to remain at historically low levels for a long period and the Fed’s balance sheet is unlikely to shrink by any significant measure in the short-term.

One possible outcome suggested by the equity derivatives team at BMO Capital Markets, is that “we could see a sharp rally in the dollar if the comments coming out of this Wednesday’s FOMC meeting indicate an end to the Fed’s asset purchase program and/or a more neutral stance with regard to future interest rate policy,” (they suggest buying the dollar bullish exchange-traded fund UUP May 21 calls at 37 cents).

A much more marked reaction would follow from an announcement that the Fed would allow QE2 to expire and would not continue to reinvest the principle earned on its mortgage-backed securities holdings, which would effectively mean a move into a tightening cycle as it would begin to withdraw liquidity from the system by letting its balance sheet begin to shrink.  NusConsulting’s team believes that that would cause a pronounced and relatively immediate negative reaction in equity and commodity markets, a correction that some speculate could reach 10%. (Read Gold And Silver’s Super Rallies).

Whatever comes out of it, Bernanke’s press conference is just a prelude to June 30, when QE2 is set to expire and dubbed “D-Day” by PIMCO’s Bill Gross. While Gross has predicted a drop in Treasury prices once the market’s largest buyer (the Fed) closes its wallet, NusConsulting’s Richard Soultanian expects a smoother handoff.  “It is clear that there is no easy way to withdraw the support the Fed has been providing the financial markets and upon which the markets have now become overly dependent,” he writes, though he expects assets to gradually work their way down to more fundamentally-based price levels following the extraordinary support from the Fed. (Read Roubini On US Downgrade: Bond Market Revolt Won’t Happen).

Stocks were signaling a higher open Wednesday, with Dow Jones industrial average and S&P 500 futures both pointing toward positive territory two and a half hours before the opening bell. Crude oil was slightly higher at $112.60 a barrel, while gold made a minimal gain to $1,506 an ounce.

Bernanke’s press conference is a landmark moment, where the secretive curtains of the Fed’s policymaking decisions will be pulled aside for the world to see.  Much like the sessions held by ECB chief Jean-Claude Trichet, Bernanke’s remarks Wednesday will be sliced and diced for when and how the Fed will start to pump the brakes on the unprecedented support the Fed has been pumping into the financial system over the last three years.

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