The Deal: Wall Street Takes Heart From Fed Chair Testimony

NEW YORK ( The Deal) -- Dealmakers looking forward to a moderation in market volatility as good for M&A activity will still have to cope with a challenging economic environment that will continue to quell appetite for bold acquisitions.

That was the lesson to be taken away on Wednesday from Federal Reserve Chairman Ben Bernanke's semiannual testimony to Congress, where he characterized the environment as difficult, both economically and fiscally.

Bankers and lawyers have noted such conditions have made it hard for dealmakers to predict revenues in potential acquisitions. The contrast between a rising stock market and higher valuations against a still-stagnant economic backdrop has further dissuaded M&A.

Bernanke erred to the dovish side, noting unemployment remained "quite high" and inflation was still below target. "Our overall policy including our rate policy is going to remain highly accommodative for the foreseeable future," he said. "We continue to provide easy money to address jobs and inflation."

His tone was a variation from his comments in June, which placed greater emphasis on the prospect of a slowdown in Fed asset purchases if the economy continued to improve. Data since then has painted a mixed outlook: U.S. retail sales rose at half their anticipated rate in June, while manufacturing expanded at its fastest rate in five months in July.

Illustrating how far the economy is from a "full" recovery, the Fed chairman said he considered normal long-run unemployment as between 5.2% and 6%. The unemployment rate was 7.6% in June when Bernanke said long-term unemployment and under-employment remained key issues.

The Fed chairman said government spending cuts were likely to hit GDP by 1.5%, or the equivalent of 750,000 jobs, and restrain economic growth over the next few quarters "by more than we currently expect." Other uncertainties such as the debt ceiling -- national debt is more than $17 trillion -- were also likely to evolve in a way that could hamper the recovery, he warned.

Legislators also grilled Bernanke on the vulnerability of equity markets to stimulus withdrawal, given the strong correlation between the market rally and expansion in the Fed's balance sheet. He acknowledged a recovery in corporate profits was well ahead of a weak labor market, reassuring Congress that stronger jobs growth remained pivotal to any change in asset purchases.

Wall Street banks have shown their sensitivity to rising rates this earnings season. Since late June, 30-year fixed mortgages have risen from around 3.93% to 4.78%, triggered by the expectation of stimulus withdrawal.

Bank of America Corp. ( BAC) CFO Bruce Thompson said Wednesday on the company's second-quarter earnings call that rising long-term rates would be an immediate negative for its mortgage business, crimping demand for both refinancing and new loans. Around 83% of BofA's home loans were from refinancing, with just 17% from new purchases. Its home loan income was down 22% to $1.41 billion from the prior period, a trend broadly reflected in results from America's two largest mortgage lenders, Wells Fargo & Co. ( WFC) and JPMorgan Chase & Co. ( JPM). JPMorgan CFO Marianne Lake has warned that mortgage refinancing could dive by 30% to 40% in the second half while fresh loan growth remained tepid. Longer term, banks are expected to benefit from the rise in interest rates, reaping higher returns from new loans amid a stronger economic backdrop.

The central banker reassured Congress the Fed would "watch to see if the movement in mortgage rates has any material effect on housing" to ensure the housing market continued to support the economic recovery.

Written by Jane Searle

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