The 'Bernanke Put'—with a Currency Kicker

S&P: The Federal Reserve's bias shift is helping global markets

by Alec Young From Standard & Poor's Equity Research

The past four weeks have been grim for global equity markets, as concerns over the rapid evaporation of liquidity and a meltdown in the subprime mortgage market have sent investors fleeing.

But last week, the markets enjoyed a rally. Since bottoming on March 5, the S&P 500 gained 4.3% through March 21. This has been mirrored in emerging and developed foreign markets. The MSCI EAFE index, a proxy for developed international markets, was up 4.1%, while the MSCI Emerging Markets index rallied 7.1%. What's behind this positive activity? S&P Equity Strategy has identified two factors.

The "Bernanke Put": We think the recent weakness in international equity markets was largely caused by fears that worsening U.S. subprime mortgage delinquencies would spread to the more influential prime mortgage market, thereby crimping the spending of the American consumer, whom international markets should thank for their stellar growth over the past several years.

But on March 21, the Federal Reserve, in a statement following its March meeting, dropped language indicating a bias toward further rate hikes. This served to reassure foreign investors that, if the subprime troubles metastasize, the Fed will act to stimulate U.S. growth by lowering rates. While improving European, Japanese, and emerging market demand has rendered foreign companies less dependent on U.S. exports for growth, confidence in the health of the American economy remains a key factor in international equity performance.

The Forex Kicker: With faith in U.S. rate cuts rising, dollar weakness is accelerating as markets discount narrowing interest rate differentials. While S&P expects the Fed to ease by the third quarter, we forecast additional 2007 tightening by both the European Central Bank and the Bank of Japan. A weaker dollar enhances foreign equity returns.

Young is an equity strategist for Standard & Poor's.