As expected, this week’s FOMC meeting did not provide much in the way of surprises. Nobody in their right mind was looking for rates to be increased, but traders, analysts, and economists everywhere were waiting with baited breath to see if Bernanke & Co. would provide any clues about when the so-called “exit strategy” would commence.

In years past, investors would not be terribly concerned about when the Fed was preparing to raise rates. With Fed officials uniformly assuring traders at every turn that the FOMC was planning on keeping rates at “exceptionally low levels” for “an extended period,” this would have historically created a “party on” mode for the stock market.

Yet despite the lack of any significant changes in this week’s FOMC statement and the assumption that the Fed will not hike rates in 2010, traders seem to be obsessed with the idea of the Fed’s “exit strategy.”

Blame It On the Fed

This is probably due to the fact that the investing public now believes it was the Fed’s fault that the housing bubble and the credit crisis got out of hand. Since rates were left so low for so long, the argument is that it was monetary policy that caused banks to abandon any and all lending standards and it was monetary policy that forced mortgage brokers to create something called “liar loans” where anybody, anywhere could waltz in, say they made $200K and get a piece of the American Dream. And it was obviously the tag team of Greenspan and Bernanke that forced our nation’s regulators to look the other way when Lehman and AIG started dreaming up ways to bet trillions without any risk management strategy to speak of.

So now, instead of the markets “partying like it is 1999” in response to the reality that rates will stay low for at least another year, we have everyone who has ever hit the buy button worried about whether or not the Fed will exit at the appropriate time. These folks worry that if the Fed exits too soon the economy will surely suffer. But if Bernanke & Co. waits too long, well, the general thinking is that another bubble will surely develop!

Therefore, each and every piece of economic data is being closely scrutinized in order to determine if the Fed will need to act sooner than expected – or, maybe later than expected. However, the data that has been released recently has not exactly been uniform. Some reports show the job market is improving while others show it getting slightly worse. Some data show manufacturing on the rise and others, well, not so much.

What We Learned

But we did learn something from the Fed statement this week. While the state of the jobs market is still up in the air (well, okay, we should admit that things are definitely getting less bad and are projected to improve in the coming months), the Fed DID acknowledge that the financial markets have improved dramatically. And if you will recall, it was the worry that the financial system was going to collapse that sent assets of all colors, shapes, and sizes into the tank.

Thus, from where we sit anyway, the idea that the FOMC is far less concerned about the financial markets is indeed a step in the right direction. In fact, the sentence in the FOMC statement addressing the financial markets was dropped from second place to fifth place within the opening paragraph. It also characterized financial market conditions as "more supportive of economic growth."

The Fed also confirmed that it will cease most of the special programs it created to stave off Banking Armageddon on February 1, 2010. The alphabet soup list of liquidity facilities being ended include the AMLF, CPFF, PDCF, TSLF, and the central bank liquidity swaps, which have already been winding down on their own.

Don’t look now, but what this means is Mr. Bernanke and Friends have already put their exit strategy in motion. And from here, they would appear to have a “To Do” list that will need to be implemented. And it is this “To Do” list that investors will need to watch closely next year.

Bernanke’s List

Giving credit where credit is due, Mr. Bernanke’s To Do List was not originally our idea. We’ll have to acknowledge that Mr. Joe Kalish of NDR was the first to bring the list that Ben will be checking twice (or more) this holiday season to our attention.

Ben’s To Do List: 2010

1. Shut Down Special Lending Facilities (Check – scheduled for February)

2. Stop Buying Bonds and Debt Securities (The pencil is on the paper as we write)

3. Reduce Unemployment (Easier said than done)

4. Be Sure Banking System is REALLY Healthy Before Proceeding (Hmmm… tough call here)

5. Drain Excess Reserves from Banking System (The public won’t notice this, but the bond market will)

6. Raise Rates

While we could argue for hours as to the proper ordering of Ben’s list, the bottom line is that number six – raising interest rates – is indeed going to be last. And as anyone can see, there is a LOT to be done before the FOMC can get around to jacking up interest rates.

THE Trade in 2010

Many analysts believe that the key to 2010 will be getting the timing of number six right. But an important thing to keep in mind is that market rates will start to rise LONG before the Fed starts to push up the Fed Funds and Discount Rates. In fact, one analyst predicted on Friday that the yield on the 10-year would be at 5.5% by mid-year.

Thus, we would suggest that investors of all kinds put a proxy for the bond market on their daily watch list as this will alert you to when “the market” starts to move on good ol’ #6. We would want to start paying close attention on any close by the 10-year over 3.85% on a weekly basis. And a move over 4% is definitely likely to create a stir.

We might also take note that PIMCO’s Bill Gross, who manages the world’s largest bond fund, is said to have been getting defensive in his funds lately. Since Gross describes his fund as more of a tanker than a speedboat, it is obvious that he has to start moving VERY early if he wants to get the timing right for his behemoth fund. So, the fact that he is raising cash should tell us something.

As we go into 2010, we should probably keep Ben’s To Do List handy because when the checkmarks start to be made and the economy starts to improve, it might be time to start looking for the exits in stocks.

Wishing You and Yours a Joyous Holiday Season,

David D. Moenning
Founder TopStockPortfolios.com

Positions in Stocks Mentioned: None

 

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