05/23/2013 04:59 pm ET Updated Jul 23, 2013

It's All About Ben

Wednesday's prepared testimony by Fed Chairman Ben Bernanke to the Joint Economic Committee of Congress seemed to start out as a bravura effort designed to silence recent chatter about the Fed's so-called 'exit strategy' i.e. the 'tapering' off of its quantitative easing program.

He weighed in with "a premature tightening of monetary policy [that] could lead interest rates to rise temporarily, but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further." Obviously. Pretty much an undeniable truism.

But then, in response to a question from the Committee, he stunned the markets with what seemed like a complete volte face, when he commented that the Fed could cut the pace of asset purchases "in the next few meetings," sending 10-year U.S. Treasury yields through the 2 percent barrier for the first time since they fell through the floor on March 15 on news of the first, ill-conceived version of the Cypriot bail-out.

On the same day, William Dudley, President of the New York Fed, opined on Bloomberg TV that "three or four months from now I think you're going to have a much better sense of, is the economy healthy enough to overcome the fiscal drag or not?"

This may all seem pretty arcane stuff and you may think that, unless you're a bond trader, you needn't really pay too much attention to such detail. ABSOLUTELY NOT. If you have investments of any sort in stocks, bonds (of course), or commodities, then you should be acutely interested.

After Ben's first comments, the S&P 500 hit a new all-time high and, earlier in the day, the Nikkei 225 had made yet another new high for this 'Abenomics' rally.

Let's be clear, the pace, depth and breadth of these equity market rallies is certainly not justified by economic fundamentals alone -- as I wrote a fortnight ago, those fundamentals are just 'right' in the sense that they're healthy enough to reassure investors, but not so robust that they may cause the Fed to tighten. The real reason investors continue to buy is that they are in a desperate search for returns in a low-return world and feel that cheap money will keep them 'whole' if they invest in risky assets, such as stocks.

As Bernanke also said on Wednesday, "there's no risk-free strategy right now." This was in answer to a question which suggested that the Fed's current ultra-loose policies were creating new bubbles, which may in turn burst with disastrous consequences. His all-consuming concern right now must be to avoid the kind of bond market carnage that was created in 1994 when the Fed raised rates unexpectedly, and I suspect that the debate within the FOMC is becoming much more heated with regard to how to achieve some scaling back of asset purchases without causing a similar bond market rout.

Sure, the big-guns, Bernanke, Dudley and Vice-Chairperson Yellen are all dyed-in-the-wool doves (please excuse the mixed metaphor!), but there is a vociferous contingent of more-hawkish voters (and non-voters) all the way through to the ultra-hawkish Esther George from Kansas, and when the Committee undergoes its annual rotation of regional Fed President voters next January, the cohort of hawks will be significantly strengthened. Out will go Ballard, Evans, George and Rosengren and in will come Pianalto, Plosser, Fisher and Kocherlakota.

If you assign a rating to each voter using a scale with 0 for dovish, to 5 for hawkish, and aggregate the changes, then I'd say it's 10 'out' and 16 'in'. Now this may not be due to happen until January 2014, but the markets know this is coming and will focus in this pretty soon. Yield curves are all about expectations for the future.

Even now, one suspects the make-up of the FOMC means there is an asymmetry about the prospects for Fed policy -- great data will send the hawks apoplectic, weak data will confirm the doves' fears, but nothing short of disastrous numbers will get the FOMC to vote for yet more QE.

So what to do? Watch two data points like a hawk: unemployment and inflation. The Fed has told us that outcomes for these will determine monetary policy, and unemployment is the one most likely to give surprises -- in either direction. There are good economic arguments for inflation to become extremely sticky to the downside at these low levels -- just over 1 percent, and I can't see it soaring anytime soon -- but watch the average hourly wages figure in the monthly unemployment releases. Wage/price spirals normally start with wages as labour becomes more powerful.

If June and July's employment reports contain pleasant surprises, then the three-month longevity for the risk assets rally that I predicted two weeks ago will be looking pretty much on course.