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WHEN BEN BERNANKE TREKKED to Capitol Hill Wednesday, he didn't have any magic answers to the economy's malaise. So stocks tanked and Treasury note yields plumbed lower than during the darkest days of the crisis of 2008 and 2009.
The U.S. economy faces "unusual uncertainty," the Federal Reserve chairman admitted to the Senate Banking Committee Wednesday, which meant he had no better idea of what we face than you or I.
On one hand, his prepared testimony talked about the Fed's so-called exit strategy to unwind the extraordinary purchases of mortgage-backed and Treasury securities. Bernanke also allowed the central bank would take further measures to expand liquidity should what it has done doesn't seem sufficient.
In other words, it seemed as if the Fed chairman could go either way. Not a comforting thought for those who place their faith in omniscient central bankers.
Those cock-eyed optimists who believe in the strength of the economic recovery were disappointed that Bernanke didn't reaffirm their faith. Some of them are in high positions, including on the Federal Open Market Committee.
On the other hand, Bernanke failed to give credence that the Fed would take extraordinary steps to ease monetary policy further. The notion du jour was that the central bank would lower the 0.25% interest rate it pays on excess reserves. That supposedly would induce them to lend out some of the $1 trillion of excess reserves they sit on, a dubious proposition at best.
All of which provoked Sen. Jim Bunning, the retiring Kentucky Republican, to ask if the Fed had run out of bullets. To which Bernanke replied to the former major league pitcher to the negative.
What the market realized is that the Fed is out of magic silver bullets. Notwithstanding its denials, all it can do at this point is hold its federal- funds rates target at 0-0.25% (probably closer to the low end of that range.)
As a result, markets did the adjustment instead. As noted here previously, ("The Shape of Things to Come", July 21), the yield curve has anticipated future interest-rate increases. Bernanke's testimony lowered those expectations.
Particularly, the Treasury two-year note fell to a record low of just 0.55% in Asia Thursday, a return that is consistent with continued near-nil money-market rates well into 2011 and perhaps 2012. The benchmark 10-year note returned to its recent low of 2.85% while the 30-year bond yield dropped back to 3.88%.
Beyond the Treasury market, the question for investors is how do those paltry returns square with expectations of positive if not robust earnings growth? Once again, many companies' top lines are coming in on the light side, even if bottom-line numbers meet or exceed analysts' (lowered) expectations.
During the 1970s, it was recognized that price-earnings multiples should be lower given inflation's magnification of earnings and the competition from high interest rates. But do low inflation and interest rates necessarily translate into high P/Es?
If the deflationary forces that push interest rates to once-unimaginably low levels also depress revenue and eventually earnings growth, equity investors should pay a lower multiple of future earnings that are unlikely to rise significantly.
While Washington's attention was distracted by President Obama's signing of the financial-regulation reform bill, the market focused on government's impotence in turning the economy around. All of which left investors in U.S. stocks about 1.3% or $200 billion poorer for that lesson learned.
Email: online.editors@barrons.com
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