Wall Street waiting with baited breath for the cavalry … but will they show up?

There’s been one heck of a rally in risk assets since late July. Stocks are up. Junk bonds are up. Volatility is down. Even the lowly euro currency has tried to climb back from the dead.

What’s driving this action? Wall Street is expecting the central bank cavalry to ride to its rescue! Not just here in the U.S., but also in Europe.

The only problem?

Each and every time they’ve done this in the past couple of years, disappointment has ensued. Policymakers on both side of the Atlantic have let them down. And we’ve seen a renewed plunge in many markets and risk appetite.

So what IS going to happen? What key dates should YOU be watching? Let me get right to it …

Jackson Hole Conference Is
Ben Bernanke’s Moment —
Will He Shine?

Every year, the world’s top central bankers gather in Jackson Hole, Wyoming for a symposium hosted by the Kansas City Fed. This year’s event is being especially closely watched because of the potential for “QE3” from the Fed.

Chairman Ben Bernanke famously hinted at QE2 in his 2010 symposium speech, and Wall Street is practically salivating over the prospect of a repeat this year. According to the bullish script, Bernanke’s latest speech on August 31 would be followed up by actual policy action at the Fed meeting that comes shortly thereafter on September 13.

But here’s the thing: Previous QE bouts have occurred when inflation expectations were tanking, the stock market was tanking, and confidence was falling apart. The exact OPPOSITE is going on now — investors are dogpiling into risky junk like mad. And we’re seeing headlines like “Apple now worth the most of any U.S. stock in history!”

Meanwhile, I just paid $4 a gallon to fill up my gas tank. Corn, soybean, and wheat prices are at or near their highest level ever. And market-based indicators of inflation are perking up … right as we head into the heart of a hotly contested election!

I simply don’t see Bernanke having the economy or political cover to print more money at this time. So I’m incredibly skeptical we’ll get ANYTHING noteworthy on August 31, or at the Fed’s September meeting. That could leave a highly juiced market high and dry!

ECB Next up in the Spotlight —
Will IT Deliver?

Truth be told, though, what the Fed does is arguably less important than what the European Central Bank does. Punch up a chart of Spanish stocks, the U.S. 10-year yield, the euro currency, or just about every other market indicator there is. You’ll see they look practically the same.

My inescapable conclusion?

How far will the ECB go to fight the crisis?

Europe is driving the bus! Wall Street hot shots are convinced the ECB will launch a new program to buy Spanish and Italian bonds in size, possibly as early as its next policy meeting on September 6. The latest scuttlebutt is that the ECB will arbitrarily set “caps” for sovereign bond yields in troubled countries, then buy all the bonds they need to in order to defend that cap.

Meanwhile, investors are expecting Germany’s constitutional court to rule in favor of bond purchases by Europe’s fiscal bailout funds, the ESM and EFSF. Such a decision on September 12 would underpin risk appetite even more by allowing a “double barreled” approach to bring down European yields.

As if that weren’t enough, Greek officials are currently panhandling around Europe once again. They want lenders to relax — yet again — the terms of their bailout loans, and to pony up more dough!

The problem, once again, is that Germany is going to be called upon to foot the bill for all of this. It would also see ITS bond yields go up under any bailout scheme, and its inflation rate rise. The same forces driving up food and fuel costs here in the U.S. are at work in Europe!

I just don’t see how the inflation-phobic Germans will sit idly by while those problems get even worse.

Risk Extremely High!
My Recommended Response …

The way I see it, we’ve had a tremendous “risk on” rally that has driven the major stock market averages to roughly multi-year highs. We’ve seen volatility collapse and complacency surge. And all that has happened NOT because of an improvement in the corporate earnings picture and NOT because of an improvement in the global economy.

Instead, it stems almost completely from hopes that politicians and monetary policy makers will FINALLY get things right.

I can’t help but think of previous periods in time when the stakes were this high. In October 2007, for instance, the Dow actually made a marginal new high thanks to Fed interest rate cuts that we were told would “solve” the mortgage and credit crisis. Instead it was a final blow off that was followed by the worst market plunge in decades.

There was a lot of optimism in the summer of 2011 that Congress would solve the debt ceiling debate, too. Instead, compromise was pushed off to the last minute and the Dow plunged roughly 2,000 points in two weeks.

And how about in the summer of 2008? We had a strong six-week rally in July and August back then on the hopes that policymakers finally had the crisis licked. Then it all went to heck in a handbasket that fall.

Seems to me that a lot of optimism has been priced in — and that a dose of serious REALISM may be in store. So I’d be taking profits off the table and make sure I had some hedges against downside risk in place. A heck of a lot is at stake in the coming month. And if policymakers fail to live up to Wall Street expectations, things could go south in a hurry!

Until next time,

Mike