When Federal Reserve Chairman Ben Bernanke answered Congress’s questions on May 22 about when the central bank might begin to slow down its monetary stimulus program, his words were measured. “If we see continued improvement and we have confidence that that is going to be sustained, then we could—in the next few meetings—we could take a step down in our pace of purchases,” he told the Joint Economic Committee. He also warned that “premature tightening” could “carry a substantial risk of slowing or ending the economic recovery.”
Since Bernanke’s heroic effort to split hairs, almost every day has been Opposite Day on Wall Street: Professional traders are convinced that for now, up is down and down is up. Signs of a weak economy mean the Fed is more likely to continue its $85 billion of monthly bond buying, a practice that has kept interest rates low and bond prices high, and pushed investors into riskier assets such as stocks. Conversely, healthier data mean the Fed is more inclined to close the easy-money spigot, so traders are selling stocks on upbeat news.
Consider this run of upside-down responses: On May 30 the Department of Commerce announced that the U.S.’s gross domestic product had grown less in the first quarter than previously estimated—2.4 percent vs. 2.5 percent—and stocks climbed. On May 31 a key measure of consumer confidence came in better than analysts had hoped—and markets fell. The next trading day brought bad reports on manufacturing and construction spending. Yep, stock prices shot up a few minutes after the news broke.
The recent losses may have only tapped the brakes on a long rally. The Fed’s “quantitative easing” strategy has helped the Standard & Poor’s 500-stock index surge 16.9 percent over seven months, its longest winning streak since September 2009, to a record high of 1,669 on May 21. But with Bernanke’s remarks being echoed in the minutes of the Fed’s latest meeting and speeches by board members, the benchmark slid 2.3 percent from that day through June 4. “Now all of a sudden when you have really good news, it suggests, ‘Oh, crap, maybe the Fed really is going to stop,’ and it spooks investors out,” says Joseph Tanious, a global markets strategist at JPMorgan Asset Management. “The wild movements we’re seeing in the markets, and these gyrations, just has a lot to do with trying to make heads or tails of” what the Fed is doing.
Why are traders so fixated on the Fed? For bond investors, it’s a fairly simple calculation that higher interest rates mean falling prices. Stock investors face a more complicated choice: whether or not to take the Fed at its word that it will only remove its extraordinary support when the economy is strong enough to stand on its own.
The recent selloffs in the face of buoyant data suggest traders aren’t ready to take that leap. In interviews, several analysts cited concerns that the Fed would begin to end its easy-money policies not because the country is back on its feet, but because of fears that its bond purchases—pushing its balance sheet to $3.3 trillion—are having negative secondary effects on markets, such as creating a bubble in junk bonds. The Fed has always acknowledged that quantitative easing could distort the markets, and that it would balance that risk against the program’s impact on the economy, says Stephen Stanley, chief economist at Pierpont Securities. That means the Fed could end quantitative easing while the economy remains weak if it saw the costs outweighing the benefits, he says.
Money managers and the financial press seized on “tapering” as a buzzword for the Fed’s eventual slowing of bond purchases following remarks on Feb. 1 by St. Louis Fed President James Bullard. “We should think about tapering or adjusting the program,” Bullard said. “If you get some good data for a couple of months, maybe you’d say, ‘OK, we go back to $75 billion per month instead of $85 billion, or something like that.’ ” Other members of the Federal Open Market Committee, which sets the Fed’s monetary policy, have since piped up that the bank should keep its options open. William Dudley, president of the Federal Reserve Bank of New York, said on May 22 that any decisions on tapering were three to four months out. Eric Rosengren, the Boston Fed’s chief, said on May 29 that if economic indicators slow down, the bank should increase its purchases.
The chorus has created an “overhang of uncertainty,” says Guy Haselmann, director of U.S. rate sales and strategy at Scotiabank (BNS). “I think right now the market’s getting a little confused with all the different messages coming out of the different Fed speeches,” he says.
“You’re seeing a reintroduction of a normal amount of volatility in the markets” after months of relative calm, says Pierpont’s Stanley. “People are starting to think about the Fed again—where before, we knew exactly what the Fed was doing, and there was no reason to handicap the odds. Now, in market parlance, we say that the Fed is ‘in play’ again. The result of that may be higher or lower prices, but certainly it will mean more volatility in the markets. That in itself is an important development.”
Haselmann notes that tapering is an intermediate step before the Fed stops its purchases, which is itself an intermediate step before the bank decides whether to sell the assets on its balance sheet or hold them to maturity. Then, of course, there’s the question of when the central bank will raise the federal funds rate, which could cause bond prices to fall. That’s why bond traders aren’t dumping their holdings quite yet. “At the party, you dance near the exit,” Haselmann says he told clients earlier this year. “When you see the first guy leave, you want to be the second guy.” The price of 10-year U.S. Treasuries fell 2 percent in May.
Michael Hanson, a senior U.S. economist at Bank of America Merrill Lynch (BAC), predicts tapering won’t begin until 2014. The Fed wants to see the unemployment rate fall below 6.5 percent before it dials back, and Hanson says that doesn’t seem likely this year, especially with the effects of the budget sequester not yet fully felt.
In normal times, the Fed raises interest rates to cool an overheating economy—taking away the punch bowl just as the party is getting good, in the words of William McChesney Martin, the longest-serving Fed chairman. Today, traders are reacting to each negative headline as if Bernanke has personally wheeled in another case of tequila. Haselmann, of Scotiabank, says the Fed’s stimulus is artificially pumping up prices of both stocks and bonds, and that the party has already gotten out of hand. He ended a recent report to clients by quoting the lyrics to Bob Dylan’s A Hard Rain’s A-Gonna Fall: “I heard the sound of a thunder, it roared out a warnin’/Heard the roar of a wave that could drown the whole world/Heard one hundred drummers whose hands were a-blazin’/Heard ten thousand whisperin’ and nobody listenin’.”