Bulls sniff out another round of Fed easing

Fed Chief Ben Bernanke’s talk on Friday at Jackson Hole, WY will likely be the event of the week given the recent unexpected weakness in the economy and the many debt problems that are plaguing Europe.

Clearly, this has tripped up the bulls over the last month, taking a big toll on equities and lending a helping hand to Treasuries.

But Monday and Tuesday have come as a big relief to investors, especially the strong advance yesterday.

Many traders tend to take the final week or two of August off, and a potential lack of liquidity may be accentuating the market moves.

Bargain hunting – stocks appear to be cheap if you are betting against a recession or a near-term default in Europe – is likely a contributor to the rally.

But the biggest reason, in my view, is the lack of any damaging headlines out of Europe and the expectation that Bernanke’s Fed is ready to come to the rescue with more talk of easing.

Recall that Bernanke first hinted at what would eventually be known as QE2 at last August’s meeting in Jackson Hole. That surprised markets.  And he surprised them again in early July by lowering the bar for implementing a more aggressive monetary policy.

Inflation is higher today than a year ago but this time around, the economy is unusually fragile.
Stocks have become addicted to regular Fed injections of liquidity, and another sugar high – compliments of the central bank – seems like a good short term fix.

But the last round of QE did little for the real economy since the $600 billion in new money is currently being held by banks and is on loan back to the Fed in the form of excess  reserves.

And inflation in the U.S.is higher today while emerging market economies like India and China are hiking rates in order to contain rising prices.

The Fed may try to surprise markets by calling for further unconventional action or measures that haven’t been publicly discussed, but the last round of QE was counter-productive since it exacerbated commodity inflation and contributed to higher rates overseas, which has slowed U.S. exports.