What will Bernanke’s testimony mean to stocks?

On Wednesday Fed Chairman Ben Bernanke will testify in front of Congress and deliver his Humphrey Hawkins testimony on the state of monetary policy. The chairman will discuss the current state of the US economy, the monetary stimulus that is currently in place and potentially any fiscal measures that he believes could help the economy grow. With inflation currently near 1.1%, according to the latest reading of the Fed favorite gauge which is the personal consumption expenditures, the Fed is unlikely to alter the bond purchase program based on increasing inflation expectations.

The stocks that will be affected the most by any change to policy would be interest rate sensitive stocks. These include financial institutions, utilities, and discretionary stocks. Stocks currently do not seem to have priced in the potential for a change in bond purchases while the bond market believes that tapering is likely within the next few months.

Bernanke is cognizant of market participant’s fear over a reduction in bond purchases as was seen after he announced that tapering would eventually take place on May 22, 2013. Not only did US equities declined by 6%, but the bond market experienced one of its worst selloffs in history declining nearly 110 basis points in less than 5-weeks. The Fed chairman has also made it clear that he will not seek a 3rd term, and probably wants to begin to unwind the historic easing that has taken place over the course of the past 5-years.

The Fed is not just purchasing 85 billion dollars’ worth of bonds per month, they are also reinvesting the coupons back into the purchase program. Although a reduction to 60 billion worth of bonds is still accommodative, stock investors will likely disagree, and a correction will be in the cards if Bernanke mentioned imminent tapering.