Easy does it on the exuberance

August 3, 2009

If it keeps going like this, Ben Bernanke will have to give an irrational exuberance speech.

Today, stocks jumped to fresh multi-month highs and Treasury yields climbed after a report on July manufacturing activity made investors feel even more optimistic about the future. Sure, manufacturing is still contracting, but that’s only a minor detail for those convinced that a burgeoning economic recovery is the real deal.

The giddiness helped push the S&P 500 above 1,000 for the first time in nine months and knocked more than a point off the benchmark Treasury note, bringing the yield to 3.64 percent.

If it were just Monday, it would be easy to chalk up the gains to a sleepy summer day of trading in August when second string traders are left in charge. But this stock rally has legs, and long ones at that.

The S&P index has been on a winning streak since March and, since mid-July, when the markets began to turn on better-than-expected earnings reports and improving economic data, it’s gained more than 13 percent.

But it’s not just stocks that have been showing investors the love. In July, corporate debt and mortgage bonds — even those backed by commercial real estate loans – booked impressive gains.

Moreover, the futures market is pricing in not one, but
multiple quarter-point rate increases (that’s presuming the Fed sticks to the game plan from earlier this decade and gradually raises rates by such fractional increments) by April of next year.

And this is where it gets uncomfortable. With markets booming, it becomes more difficult for the Federal Reserve to keep the myriad lending facilities, backstops and security purchases, not to mention basement-level interest rates, in place.

The longer the markets head higher, the greater the chance they will force the Fed to remove the stimulus before the economy is ready — risking the dreaded double-dip that still haunts students of the Depression.

So, policy makers should do what they do best when they want to bring some moderation to markets: jawbone. Use the podium to signal that the rebound in markets is coming too far, too fast to be sustainable given the economic realities.

Unfortunately, irrational exuberance is already taken — and perhaps not the best phrase anyway since the stock market continued to climb well after former Fed Chairman Alan Greenspan first used those words in a speech in 1996.

Maybe something along the lines of: “Hey, company earnings are still down nearly 30 percent, the economy is still contracting and financial markets are still on life support. Easy with the optimism.”

That could slow things down a little and give policymakers and the economy more time to make sure the tentative recovery actually sticks.

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What does the phrase “rally has legs” mean? Does it refer to the length of the upward slope on a chart or that it can simply keep moving?