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Bernanke's Talk Proves Costly

Liz Rappaport

Ben Bernanke attempted to clarify last week's Federal Open Market Committee statement in his testimony to the Joint Economic Committee Wednesday. But the market wasn't wooed by his words. If anything, traders now know that the Fed shares their uncertainty about the economy's future.

The Dow Jones Industrial Average plunged as the testimony headlines ran at 10:30 a.m. EDT, but Bernanke was by no means alone in Wednesday's market psyche. Stocks staged a weak open on news of heightened political tensions with Iran and a spike in oil prices, news of an investigation into Beazer Homes(BZH), and a soft report of business spending.

After trading as low as 12,257.42 intraday, the Dow finished the day down 96 points, or 0.8% to close at 12,299.15. The S&P 500 closed the day down 0.9% at 1417.16, and the Nasdaq Composite slid 0.8% to close at 2417.10.

The cyclically sensitive parts of the market underperformed Wednesday. The Dow Jones Transportation Average fell 1.2%, while retailers Wal-Mart(WMT) and J.C. Penney(JCP) fell 1.9% and 1.7%, respectively.

Homebuilder Beazer plunged 8.4%, but finished off its intraday lows, amid revelations of a federal investigation into its lending practices. Other builders, such as KB Home(KBH) and Pulte Homes(PHM), closed down 3.4% and 2.9%, respectively.

Ultimately, Bernanke's testimony reiterated that inflation remains the Fed's chief concern but that his outlook for growth has deteriorated slightly in recent weeks. The inflation bias felt a bit obligatory given that so much of the testimony was about the Fed's adjustment to its outlook for economic growth. "Its predominant policy concern remains the risk that inflation will fail to moderate as expected," reads the written testimony.

"Today's testimony showed the markets the Fed isn't going anywhere any time soon," says Drew Matus, senior economist at Lehman Brothers, who adds that the testimony also let investors know that recession fears are as overblown as rate-cut hopes.

The bond market took heed to the hawkish talk on inflation, as the longer-duration bonds sold off in the wake of Bernanke's testimony. The 30-year bond fell 15/32 to yield 4.83%, while the 10-year note slid 4/32 to yield 4.62%. The two-year note remained flat to yield 4.56%.

"The selloff in the long end and thus the steepening of the yield curve argues bond traders thought more of the inflation talk than the business spending worries," says Don Kowalchik, associate vice president, fixed income at A.G. Edwards. In a way, it's a show of faith in the Fed, he says.

Worries about business investment were revived Wednesday as the Census Bureau reported durable-goods orders rose 2.5% in February, less than the 3.5% increase expected, while January's decline was revised to 9.3% from 7.8% previously. Aircraft orders pushed February's number higher, but the report was weak elsewhere. Non-transportation orders fell 0.1% in February, well-below analysts' expectations for a 1.8% increase.

"The Fed's continued vigilance about inflation has given long-bond investors a reason to rethink their bet," Kowalchik says. "It gives them a reason to move away from the long maturities due to inflation risk." The steeper yield curve, in turn, becomes a more positive indicator about the economy, he adds.

But Bernanke was much less reassuring about the future of the economy than he has been in recent testimony. On Wednesday, he provided plenty of evidence to support the downside risks but little to support the more-upbeat alternatives or positives, says Tom Higgins, chief economist at Los Angeles money management firm Payden & Rygel.

The burden, even in Bernanke's words, seems to fall on the consumer and whether or not they'll, well, just keep consuming.

"Consumer spending appears solid, and business investment seems likely to post moderate gains," reads the testimony. But then Bernanke proceeded to run down a laundry list of risks to that statement. They are not insignificant.

Housing "could turn out to be more severe than we currently expect, perhaps exacerbated by problems in the subprime sector," he said in the testimony. "Moreover, we could yet see greater spillover from the weakness in housing to employment and consumer spending than has occurred thus far. The possibility that the recent weakness in business investment will persist is an additional downside risk."

OK. That's a lot of risks. But a don't-fret sentence was right behind, even though it feels like a knock-on-wood kind of don't-bet-against-the consumer cliche:

"To the upside, consumer spending -- which has proved quite resilient despite the housing downturn and increases in energy prices -- might continue to grow at a brisk pace, stimulating a more-rapid economic expansion than we currently anticipate."

The "upside" feels a bit empty with no explanation for how or why the consumer will unexpectedly spend more after a marked downturn in retail sales in January and February, as mortgage woes escalate and as inflation gains ground.

Bernanke did take pains later on in the statement to explain that core inflation may moderate as rental prices decline once home ownership becomes more attractive again. But he added that the timing of such stabilization is hard to predict.

Bernanke also balanced the risks to rising inflation from high labor costs and tight levels of resource utilization. He said inflation may not kick up if productivity remains high or if companies absorb high labor costs in their profit margins.

In the question-and-answer session, Bernanke had the chance to say he does not think the economy will slip into recession this year. But "we're very uncertain" about the extent and breadth of damage to come form the housing market and the subprime mess, the chairman said.

Perhaps nothing Bernanke could have said would have reassured markets Wednesday, given the other headwinds. Oil spiked to $68 per barrel in after-market trading Tuesday on rumors of escalating tension with Iran. Oil ended the day up 1.8% Wednesday, to close at $64.08 per barrel.

"The main scenario in the markets today is Iran," says Todd Leone, head of listed trading at Cowen & Co.

The Fed can't do anything about that.