Funny how the party stops the minute people find out what time it’s going to break up.
Yesterday, Federal Reserve Chairman Ben Bernanke gave his clearest guidance yet about turning off the easy-money spigot that’s been gushing for nearly five years. Since he spoke, markets of all kinds are freaking out. Gold is near three-year lows. Oil has lost a couple of dollars a barrel. Bond prices are falling as yields rise across the board. Volatility is up, stock prices are way down. The Dow has shed more than 400 points since Bernanke’s press conference ended on Wednesday afternoon.
In a way, we’ve been waiting for Bernanke to give the sell sign for the past few years. And in a selloff, no one wants to be the last one out the door. So markets bake it in as early as possible—and typically overreact in the early days.
But even if we’re still four or five months away from the Fed easing back on its bond-buying—and much further from any chance it will start raising rates—the path is now set. Whatever ambiguity had been in the Fed’s messaging over the past several months disappeared yesterday. The Fed will stop buying bonds when the unemployment rate reaches “the vicinity of 7 percent.” That’s not to say it’ll go from $85 billion a month to zero overnight. Once the Fed decides to slow down bond purchases, “We would continue to reduce the pace of purchases in measured steps,” Bernanke said.
Most economists think the tapering process will play out over six months or so. Tom Porcelli, chief U.S. economist at RBC Capital Markets (RY), thinks the pullback will begin in October and end sometime in the first quarter, when the unemployment rate will hit 7 percent.
The question is how long this selloff lasts, which is to say: How much of the rise in asset prices over the past few years has been purely the result of easy money? How long until we start hitting fair value? As of Thursday, the price-earnings ratio of the S&P 500 was about 15.66, which is right around the average over the past five years. From 1995 to 2002, however, the p-e averaged 24.
Then there’s the risk that worried investors will spark a rise in long-term rates that could put the brakes on the economy even before the Fed slows its bond buying. So far, economists don’t see that happening. “I don’t think expectations suddenly changed after 2 p.m. yesterday,” says Michael Feroli, chief U.S. economist at JPMorgan Chase (JPM). if anything, economists have been slightly raising their expectations for growth recently. The average forecast among 76 economists surveyed by Bloomberg in June was for the economy to grow 1.7 percent in the second quarter and 2.3 percent in the third; those are both up from the average forecasts from May.
Yet as I write this, the selloff continues. Adding fuel to the decline are ugly data from the emerging market. China is slowing down more quicky than anticipated. Manufacturing there is turning out to be weaker than forecast. The World Bank just cut its estimates for China’s GDP growth this year from 8.4 percent to 7.7 percent, which would be the slowest pace since 1999. There’s also a broader emerging-market unwind taking place, as investors pull money out of a wide range of developing countries. “Emerging markets have their own issues to deal with at the moment,” says Porcelli. “Bernanke wasn’t the catalyst for the pullback we’re seeing there, but it doesn’t help.”