The new man at the helm of the US economy

Fed chairman Ben Bernanke's maiden testimony in February reassured the bond markets with soothing tones of continuity with the Greenspan era. But with question marks still hanging over his inflation policy, and how much of an impact his personal style of chairmanship will have, Dalia Fahmy assesses how his tenure is likely to affect the credit markets

It took a while for the bond markets to warm up to Ben Bernanke. When President George W. Bush announced in October he had appointed the 53-year-old chairman of the White House Council of Economic Advisers and former Federal Reserve board governor to replace Alan Greenspan, 10-year Treasury yields jumped six basis points. Market observers blamed Bernanke's allegedly loose stance on monetary policy, his weaker charisma compared with Greenspan, and his lack of experience in the 'real world', having spent most of the past 30 years teaching economic theory in the ivory towers of Princeton and Stanford Universities.

Since then bond markets have calmed down. Market participants are putting the reaction in perspective, pointing out that when Greenspan was picked to replace Paul Volcker 19 years ago, Treasuries soared 35 basis points. "The market got killed that day," says Brian Robinson, bond strategist at consultancy firm 4Cast in New York. "Markets don't like uncertainty, and they had a lot of faith in Volcker. Greenspan was considered somewhat of an unknown who ran a consulting firm."

Staying the course?

While there's no shortage of speculation about how Bernanke will manage monetary policy, most market participants are willing to give him a chance to settle in first. For now, they say, he is likely to stay the course. Pierre Ellis, chief fixed-income economist at Decision Economics, says Bernanke will probably be a neutral force in the market at least during the first year, and it's unlikely he will stray far from the path that Greenspan has laid out.

"Bernanke has to establish that he can keep the trains running on time," says Ellis. "But there's no reason to expect he'll represent a significant shift. If it ain't broke, don't fix it."

But even if Bernanke's biggest challenge is to ensure continuity, Greenspan is a tough act to follow. For starters, Bernanke is said to lack Greenspan's powerful charisma. "He doesn't have the gigantic Greenspan reputation, but that's because he just got here," says David Rolley, co-manager of the Loomis Sayles $1 billion Global Bond Fund. "So decision-making may be a little more by consensus for a while. It takes years for people to put a personal stamp on policy."

Bernanke also differs from Greenspan in his communication style. The new chairman announced early on that he plans to make the Fed more transparent, by discussing the board's opinions and policy expectations more openly. He has even advocated setting an inflation target. Greenspan had started to open up the Fed in recent years, for example introducing the bias statement released at the end of every Federal Open Market Committee (FOMC) meeting that indicated where policy might be headed. Only time will tell whether more openness will help the market or hurt it.

Some argue that Greenspan managed to stay one step ahead of markets by speaking in code and always keeping traders guessing. Diane Swonk, chief economist at Mesirow Financial, says Bernanke is more likely to tolerate open public debate among FOMC members, "which could confuse financial market participants who have grown accustomed to hearing a more uniform message from the Fed".

Joel Naroff, of Naroff Economic Advisors, says more transparency is always better, at least as a way to reduce volatility. The question, he says, is whether Bernanke will really prove to be much more transparent. "Once you could figure out Greenspan speak, he was always reasonably clear," he says. "Everyone says Bernanke is in favour of more transparency, but unless they are going to televise the FOMC meeting, I don't see how that's possible."

But the differences between Greenspan and Bernanke are not just about personality and leadership style. Ellis says because Bernanke's experience has largely been academic and he hasn't spent years like Greenspan interpreting real economic data, it remains to be seen whether he has the same prophetic ability to read markets. "Bernanke hasn't been at the Fed long enough to understand the business of predicting the economy," he says, referring to Bernanke's three-year stint on the Fed's board of governors that ended last year. "Greenspan persisted in views of the economy even when there was intense opposition against him. And in the end he turned out to be correct."

Many point out that comparing Bernanke with Greenspan this early in the game is unfair, since the former chairman spent years polishing his credentials as market soothsayer. They argue that Greenspan's market savvy was painstakingly acquired as he navigated one crisis after another: the 1987 stock market crash, the Mexican Tequila Crisis, Asian Flu, the Long-Term Capital Management debacle, the internet bubble, September 11. The list goes on.

Plus, they say Bernanke has academic excellence on his side: the Massachusetts Institute of Technology PhD is said to be one of the country's most knowledgeable economists and monetary policy experts. (His promise started early: at the age of 11 he won the South Carolina state spelling bee, and at Harvard as a 23-year-old, he won first prize for best undergraduate economic thesis.)

On the Fed board, Bernanke also developed a reputation for digging deeper than his colleagues for data. According to a BusinessWeek account, at the Fed's routine fortnightly meetings, Bernanke would often ask Fed staffers for additional analysis on economic data. When Greenspan would step in to give his own explanation, Bernanke would listen politely and then persist: "Be that as it may, I'd still like the staff to get back to me."

Inflation

The biggest question about Bernanke's approach, however, is how he intends to handle inflation. Following his nomination, Bernanke was perceived to be more dovish on inflation than Greenspan based on comments he made in his early years as Fed governor. At the time, following the stock market declines of 2000 and 2001, markets were concerned about the possibility of recession and deflation, and Bernanke emerged as a strong advocate of reviving the economy with looser monetary policy.

In his most often-quoted comment that has earned him the nickname 'Helicopter Ben', Bernanke referred to a statement by the economist Milton Friedman and pointed out that the government could fight deflation by staging a "helicopter drop" of money into the economy through tax cuts and Federal Reserve monetary stimuli. The remark was widely interpreted to mean that the Fed would invest money to spur growth, rattling bond market participants who couldn't banish the frightening thought of this influx of cash fuelling rampant price increases.

Since then, Bernanke has said his remarks were taken out of context, and his defenders argue that he only spoke hypothetically, at a time when many were more worried about deflation than inflation. In fact, his open and persistent calls for a formal inflation target are now beginning to cast him in a more hawkish light.

During his confirmation hearing before the Senate Banking Committee in November, Bernanke argued that a more formal target could help improve transparency and market stability. "By naming a potential range - which I emphasise is no fait accompli; it's something that's going to be discussed and will be consulted with members of Congress - but naming such a range doesn't change the underlying dynamic," he told senators. "It's only an attempt perhaps to provide a bit of additional confidence...a bit of additional certainty to the markets about the Federal Reserve's long-term objective."

Inflation targeting may come in handy for Bernanke now, some say, given that he is taking over the Fed at a potentially treacherous economic juncture. The Fed has been hiking interest rates since 2004, raising them to 4.50% from 1% in order to soften growth and ease the economy into a soft landing. Now it has reached what most expect will be the end of the tightening cycle, with at the most another hike this year that would bring the Fed funds rate up to 4.75%.

If Bernanke is lucky and doesn't encounter unexpected disruptions, say market observers, his work on the interest rate front should be cut out for him this year: after its latest meeting on January 31, the last before Bernanke took over, the Fed left the door open for more rate hikes, saying "some further policy firming may be needed" to keep inflation under control.

Some argue that Bernanke may have to raise rates by another 25 basis points to 4.75% at the March 28 meeting, just to show that he's tough on inflation. What happens after that is open to debate, and that's where the new Fed chairman could trip up. "The thing to focus on now is how successful the Fed will be in getting the economy to slow without going into recession," says Tom Murphy, head of investment-grade credit at RiverSource Investments. "They are always more interested in controlling inflation, and that could mean they'll overshoot."

However, Murphy also points out that much of the discussion about whether the Fed will raise rates one more time is pointless, since liquidity conditions aren't materially affected by a 25 basis point difference. "People are spending too much time on that," he says. "We already had 14 rate hikes; we're relatively close to the end game."

If the Fed does in fact stop at 4.75%, most market participants expect a benign credit environment for the rest of the year, a slight slowdown in economic growth from 3.6% estimated in 2005, and stable spreads until credits react with the inevitable widening at the end of the year.

And regardless of their outlook on rates, they agree that Bernanke will closely watch economic data for cues on how to proceed further. The open question of which data Bernanke will be watching, however, is the source of some uncertainty.

"Greenspan had a reputation for having his pet series of data that he watched religiously, and we would expect Bernanke to have his own favoured data," says Edwin Ferrell, director of research at 40/86 Advisors, pointing out there may be some volatility while the market figures out which numbers Bernanke trusts.

Regardless of which data Bernanke ends up relying on, there's no doubt that several economic indicators have been at the hot end of the Fed's comfort zone. The unemployment rate currently at 4.9%, for example, could start signalling inflationary potential if it fell any further, analysts say.

There are also concerns about possible price pressure from rising energy prices. The current standoff between Iran and Western governments, which want Iran to suspend the nuclear energy programme it resumed late last year, could further destabilise the Middle East and cause the price of oil to jump. "Geopolitics is the biggest single 'gee whiz' that people aren't looking for," says Loomis Sayles' Rolley. "Iran sells oil. And if we put sanctions on them, what is the price of oil going to do?"

While credit market participants agree that further rate hikes are necessary to ward off inflation, they worry about what effect the combined interest rate hikes and potentially rising energy prices might have on corporate earnings, and by extension, the corporate bond market.

The US economy has already begun to show signs of slowing down. In fourth-quarter earnings reports released in January, several companies missed their targets, especially banks that have been hit by a flat yield curve. At the same time, fourth-quarter US gross domestic product slowed unexpectedly to 1.1%, as consumer spending rose at the slowest pace since 2001.

"As credit metrics begin to weaken, the cyclical sectors in particular will look vulnerable," says 40/86 Advisors' Ferrell, mentioning paper and forest products and the chemical sectors in particular.

Like others in the market, however, Ferrell doesn't expect credit spreads to start widening until late in 2006.

Market participants also worry about the effect that excessive interest rate hikes might have on the housing market. "There are housing bubblets all over the country. Some of them are being deflated slowly, but in other cases the deflation is gathering steam," says Naroff from Naroff Economic Advisors. "Once buyers start seeing they are getting the upper hand, the pleasantries will be over and the landing will be a little bit harder than people are projecting right now."

Analysts who believe in the bubble say that an unexpectedly sharp rise in interest rates could scare buyers away and send the market crashing.

Walter Schmidt, head of mortgages at FTN Financial, doesn't agree: "The market is making too much of the housing bubble. I don't think it's a major issue," he says. Schmidt points out that US homeowners have varying interest rate exposure because of the diversity of mortgage products and maturities, which means that they won't all react to interest rate moves in the same way. Michael Youngblood, managing director of asset-backed securities research at investment bank Friedman Billings Ramsey, agrees, pointing out that there's no such thing as a single housing market, and that correlation between prices in different cities varies widely.

US cities that derive their spending power largely from manufacturing, such as Detroit, might be hit earlier and more severely, while those that rely largely on services, such as New York would be hit later and less severely. Plus, the bubble has already started letting out steam in some parts of the country, which makes a violent crash less likely.

As a result, says Youngblood, as long as the Fed remains reasonable with its rate hikes by stopping at 4.50% or 4.75%, mortgage default rates should remain low, keeping investors safe. But if the Fed is forced to raise rates beyond 5%, the housing market might start to suffer and defaults might rise.

Yield curve

Perhaps more closely watched by the market than any macroeconomic indicator is the yield curve, which historically has been one of the most accurate gauges of whether a recession is ahead. The yield curve has flattened significantly and even inverted occasionally over the past year, with short-term rates rising due to the Fed's rate hikes and long-term rates remaining fairly flat as a result of aggressive foreign buying.

A flat yield curve is usually the result of a shift in risk perceptions: investors accept lower yields on long bonds, despite their greater riskiness, when they expect short-term yields to fall in the future, which can happen when the Fed cuts rates in a recession. In fact, flat yield curves have preceded five of the past six recessions since 1976, leading some to worry that another sharp economic slowdown is around the corner.

But many, including several senior Fed officials, argue that this time is different. They point out that long-term rates have been artificially depressed because of heavy buying by foreign investors, and add that even though the Fed has been raising rates, 4.50% is still a generously low level that won't lead to recession. "Some of the discussion [around the yield curve] reminds me of medieval times when the arrival of a comet would spark a sort of apocalyptic hysteria," Richmond Federal Reserve president Jeffrey Lacker told an audience in January. "Concerns about inverted yield curves are somewhat overblown."

Still, the yield curve's unusual shape has thrown fixed-income investors out of kilter. Long-term bondholders used to earning more yield have barely seen any returns. Those in money-market and short-term bond funds did better.

However, some have managed to do well with a barbell positioning, with a focus on either end of the curve. RiverSource's Murphy says: "We have generated a large percentage of our alpha thanks to our positioning along the curve." He explains that given the choice between five- and 10-year notes, his fund has generally preferred five-year holdings. But in some sectors, such as media, cable and utilities, where the 10-year to 30-year curve has remained fairly steep, the fund has bought the 30-years in order to collect yield.

Now, many investors are recommending migrating to the short end of the curve in order to take advantage of expected steepening later this year.

While few expect Bernanke to tailor monetary policy toward the shape of the curve, most expect it to normalise somewhat by the end of the year as the Fed puts a stop to rate hikes, at least temporarily. Unless, of course, the new Fed chairman decides to try a completely new approach to monetary policy and doesn't stop raising rates as expected. Then, all bets are off.

High yield volatility

The biggest impact of Bernanke's appointment on the high-yield market, says Kingman Penniman, head of research provider KDP Investment Advisors, will be the increased market volatility in Bernanke's early tenure.

Volatility would have increased anyway as the Fed neared the end of its tightening cycle, he says, but Bernanke's approach to monetary policy could also play a role. Because Bernanke's decision-making style is more dependent on economic data releases, as opposed to Greenspan's long-term, almost intuitive approach, the high-yield market may be more sensitive to fluctuations in monthly numbers.

"There's an expectation we won't get the kind of foresight we had been getting under Greenspan, and that could increase volatility," says Penniman.

Still, market participants argue that interest rates are still relatively low and spreads to Treasuries still attractive. Once a widening takes place later this year, Penniman recommends buying short-term paper to take advantage of the steepening yield curve.

Margaret Patel, manager of the $8 billion high-yield fund at Pioneer Investments, predicts a benign environment in which the Fed raises rates gradually, leaving companies and investors with sufficient access to capital in order to keep the high-yield market healthy. Defaults are likely to remain low, she says, which also makes for a positive backdrop.

Banking on Bernanke

For banks, which are particularly sensitive to interest rates, Bernanke's approach this year will be crucial. The flatness of the yield curve has already started hitting earnings at banks, which can no longer rely on the wide difference that usually exists between the low cost of short-term borrowing and high income of long-term lending.

Partly as a result, financial services firms including Bank of America and JPMorgan Chase in January reported disappointing fourth-quarter earnings. And while a pause in Fed rate hikes should help as banks can begin to borrow funds more cheaply, the tight yield curve will continue to hurt.

Still, bank credit might not be a bad investment in 2006, given the alternatives, says Kathleen Bochman, a bank credit analyst at Gimme Credit. Bank bonds, because they are predominantly highly-rated investment grade, are likely to be less sensitive to disappointing headlines or potential early blunders by Bernanke.

"Bank spreads will probably be a little wider relative to other corporates, but they're still a decent place to be compared with other industrial credits," she says.

MBS investors stay vigilant

One of the most vulnerable sectors to Fed policy this year is the mortgage-backed securities (MBS) market. Sensitive to both interest rate and housing market pressures, MBS investors are likely to watch Bernanke's actions closely.

"One thing that the MBS market doesn't like is an inverted yield curve," says Walter Schmidt at FTN Financial, pointing out that the yield curve is likely to invert if the Fed continues to push short-term rates higher. If Greenspan were still at the helm, he argues, the Fed would likely stop at 4.50%. But since Bernanke will have to prove his toughness with inflation, an additional hike to 4.75% is likely, he says.

An inverted yield curve hurts the MBS market in two ways. One the one hand, it cuts into spreads since much of the market is made up of 30-year bonds. On the other hand, it puts the creditworthiness of the underlying securities at risk, since many borrowers nowadays have short-term adjustable rate mortgages, which become more difficult to repay as short-term rates rise.

MBS analysts recommend that investors begin preparing for a steepening of the yield curve by staying in the short end. Michael Youngblood at Friedman Billings Ramsey recommends buying short-term maturities, holding floating- and adjustable-rate mortgage loans, and on the fixed-rate side, picking 10-year to 15-year, and 20-year amortisation securities.