Why the Markets Are Rattled By the Fed’s New Normal
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The Fiscal Times
June 23, 2013

At his press conference Wednesday, Federal Reserve Chairman Ben Bernanke sought to soothe those who have been enjoying the stock market party of recent months, even as he indicated that he would soon be taking away the punch bowl.

“Our policies are tied to how the outlook evolves. That should provide some comfort to markets, because they should understand, I hope, that we will be providing whatever support is necessary,” Bernanke said in response to a reporter’s question, adding that, “We are determined to be as clear as we can, and we hope you and your listeners and markets will be able to follow what we’re saying.”

Whether the markets followed or not, they clearly found little comfort in the statements from Bernanke and his colleagues on the Federal Open Market Committee. Instead, the S&P 500 closed out Wednesday with a 1.4 percent loss and then followed that by plunging 2.5 percent, the steepest one-day drop since November 2011. After a small rebound on Friday, the index's losses for the week totaled 2.1 percent. it is now 5.6 percent below the all-time high reached on May 22, the same day Bernanke told Congress that the Fed's policy-making committee could decide to reduce its asset purchases in its next few meetings.

The Fed wasn’t the only factor spoiling the party this week. Fresh concerns about the Chinese credit markets and manufacturing sector only added to the unease as investors tried to adjust to a changing market environment.

Yet the Fed’s forecast, accompanied by fairly optimistic economic projections for next year and by what many – including St. Louis Federal Reserve President James Bullard – perceived as relatively little concern about low inflation expectations, signaled a more hawkish stance. “Going forward,” Bernanke said at his press conference, “the economic outcomes that the Committee sees as most likely involve continuing gains in labor markets, supported by moderate growth that picks up over the next several quarters as the near-term restraint from fiscal policy and other headwinds diminishes.”

That outlook injected new risk into the markets. “Given that it has taken several years to nurse the economy into its current state of health, we had expected the Fed to err on the side of caution in assessing the prospects for recovery,” J.P. Morgan’s chief U.S. economist, Michael Feroli, wrote in a note to clients Friday. The Fed’s optimism could still turn out to be justified. “Were the economy to stumble, however,” Feroli wrote, “history may look back on this meeting as one where the Fed once again jumped the gun in embracing better data.”

Even if the Fed isn’t acting prematurely, it will be creating new uncertainties for investors. Bernanke tried to create a glide path to a new era in which the Fed pulls back its extraordinary support measures, says Brad McMillan, chief investment officer of Commonwealth Financial Network, an independent broker/dealer with more than $71 billion under management. The Fed chairman may have hoped that the markets would adjust gradually to that new view on the horizon. The markets, instead, focused on the final destination – a time when the Fed not only withdraws stimulus, but raises interest rates. “The market did what markets do and said, ‘Ok, if that’s going to happen [eventually] we’re going to trade on that today,’” McMillan says.

Part of the problem, McMillan adds, is that traders are unsure about where prices should be without the Fed’s huge presence in the market. “The Fed has been buying bonds for so long, we really don’t have any sense of where prices would be without that manipulation,” he says. That uncertainty may contribute to further price swings: “I think the markets are trying to find out what the market-clearing price is, and until we find that we’re going to have that volatility.”

Investors may also doubt whether the bankers, now that they have sketched out a road map, can respond to changing economic data as precisely as Bernanke suggested. “The Fed staff is bright, competent and well educated. Yet, the history of Fed projections is, at least by Wall Street folklore, spotty at best,” UBS’s Art Cashin wrote Thursday.

It’s not just Wall Street folklore. As Dylan Matthews of The Washington Post illustrated this week, the Fed’s forecasts since 2009 have been consistently over-optimistic, even as the projected growth rates have been revised lower and lower.

Despite those doubts and the lingering uncertainty about the timing of the Fed’s exit, the market’s dramatic move came as a surprise to many – after all, Bernanke had just told Congress and the world that tapering could start soon. “The reaction looks a bit exaggerated, although market swings can temporarily become self-perpetuating at times like this,” noted Jim O’Sullivan, chief U.S. economist at High Frequency Economics.

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Yet the stock pullback, particularly after a long and relatively smooth bull run that had taken the S&P 500 and Dow Jones industrial average to record highs, shouldn’t have been a shock. The market slumped after the Fed ended its two previous rounds of quantitative easing, as Peter Boockvar, the lead portfolio manager for Morgan Stanley’s Excelsior Wealth Management, noted in an email. After QE1 ended in March 2010, the market continued to rally for a few weeks before falling 16 percent in the months that followed. After QE2 ended in June 2011, a similar pattern followed, with the S&P 500 eventually dropping 18 percent from its peak.

Even with those corrections along the way, the stock market’s Fed-fueled gains have been robust. The Dow Jones industrial average has gained more than 12 percent this year, and more than 17 percent over the past 52 weeks. The index has soared 125 percent since March 9, 2009.

“I would call this potentially a healthy adjustment. It’s been incredibly long since the last meaningful adjustment. We were due,” says McMillan. “The Fed is moving back toward normality. It has to move back to normality. Regardless of whether you think it should have been done a year ago, today or a year from now, it has to be done.”

Executive Editor Yuval Rosenberg oversees coverage of business, the economy, technology and Wall Street. A former web editor at WNYC, Fortune and Newsweek, he also writes on a wide range of subjects.