Will the Fed Be Able to Rein in Volatile Markets?
Business + Economy

Will the Fed Be Able to Rein in Volatile Markets?

iStockphoto/The Fiscal Times

The Federal Reserve is expected to fine tune its policy message when it meets in the coming week, but whether it is able to rein in volatile financial markets is another matter. The two-day Fed meeting ends Wednesday with a statement, economic forecoast and a press briefing by Fed Chairman Ben Bernanke; it also follows a rough several weeks for markets, where interest rates have risen, forcing a reassessment and shaking out of asset values across global markets. 

There is a heavy economic calendar, including housing and consumer level inflation data, but the focus is honed on what the Fed will say about its quantitative easing program and whether it will signal that it is going to start paring back on its $85 billion monthly bond purchases.  

"I think it's time for them to establish some clarity," said Ward McCarthy, chief financial economist at Jefferies. "I think in terms of near-term balance sheet guidance and rate guidance, nothing will change. However, I think they will also add additional guidance that's specifically related to the timing and rate of the eventual wind down."

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Traders are also watching the G-8 meeting in Ireland Monday, after the U.S. this past week said the Syrian government has used chemical weapons and it would now help arm the rebels in the civil war. That helped drive the price of oil to a nine-month high Friday.

"Obviously where it's situated next to Iraq and the spillover-affect into Turkey threatens Iraq's northern exports so there's potentially real amounts of oil hanging in the balance," said John Kilduff of Again Capital. Russia disputes the allegations about chemical weapons, and that adds to the tension in the region, he said.

West Texas Intermediate touched $98 per barrel Friday. "$98 is an important level. We've been here twice before over the past year…There's no such thing as a triple top. We'll likely take out $100 next week as a result," he said.

Markets have been on edge about a "tapering" of the Fed bond buying program, pricing in a higher rate environment which has triggered selling across fixed income markets and in equities. The Fed QE programs have been seen as favorable to stocks, sending investors further out the risk spectrum, driving up the prices of everything from junk bonds to equities.

At the same time, Japanese monetary policy this year had driven the yen sharply lower and Japanese stocks sharply higher, but that trend has been painfully and rapidly reversed, sending shock waves across global markets in the last several weeks as traders unwind carry trades.

The talk of "tapering" by Fed officials, at the same time, has jolted markets which had a longer view of when the Fed might begin to wind down its programs. McCarthy said the Fed could suggest that it would start the process in the fourth quarter and complete it in the middle of 2014, with the caveats of an improving economy, inflation and the health of financial markets. Other Fed watchers expect the Fed could begin paring back as early as September, and others don't expect it until next year.

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"They're not going to give you a date and a time, but I think they can give us a more specific time frame and then as the date approaches adjust it forward or back as the economic data releases suggest they should," McCarthy. "On the clarity front too I think they need to be a little bit more focused on inflation. Maybe there's a dual mandate but the way things appear to be right now is that inflation has been kind of lost in the shuffle here." For that reason, he will be watching CPI inflation data on Tuesday, noting while the Fed has been easing CPI has decelerated from 3.9 percent in September, 2011 to 1.1 percent.

The Fed now is in the spotlight and is in a tough position, since it has elevated rate expectations at a time when the economy is performing unevenly. But its comments have also reversed the prices of assets that some strategists feared were getting overly inflated, like high-yield corporate debt. "One could argue the last thing the Fed wants to have happen is a stock bubble, or a housing bubble. We're not in a bubble in either of those but maybe they want to nip it in the bud," said Scott Wren, senior equity strategist at Wells Fargo Advisors. "Everything is so orchestrated. Seemingly there could be purpose behind the confusion."

Whether intentional or not, the Fed's impact on markets may have given it an edge in preventing bubbles. "The Fed wants to avoid reintroducing the one-way view on markets and make investors understand that what decisions ultimately should be built upon is not the idea that the central bank will remain active in perpetuity, but in underlying fundamentals," said Tony Crescenzi, portfolio manager with Pimco.

Crescenzi said he does not expect much change from the Fed. "The script is pretty simple. They're not going to taper now. If he can lay the groundwork for letting data dictate the policy…it will keep markets in a more stable condition when tapering occurs and advances. We would expect the bond buying to last into next year. The key is the policy rate. So long as that is kept at zero or near it, that's enough to keep rates from moving meaningfully."

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Crescenzi said the move to higher rates exposed problems in the financial markets, and the bid/ask spread across the spectrum of spread products roughly doubled as rates climbed, in high-yield, investment grade, emerging market debt and municipal bonds. "Investors are realizing the plumbing is somewhat broken in the bond market and the financial system, so when investors go to sell they find fewer primary dealers willing to warehouse risk," he said.

"This illiquidity has caused assets to get harmed indiscriminately, so the Fed's ability to suppress volatility in rates has been harmed by the reduction in liquidity in the financial system. This is in part because the Fed's own actions have caused investors to lever up and go out the risk spectrum at ever higher prices. The goal should be to calm investors, mainly by suppressing volatility, he said, adding that would help lower rates.

The Fed is not likely to change the wording much on the economy, he added. "The more ho hum the statement is the more stabilizing it will be, and Bernanke will be left to emphasize the points he wants to emphasize," he said. The Fed should also indicate it will be accommodative for a long time, emphasizing that reducing purchases is not a tightening of policy, since rates remain at zero and the Fed holds its bond purchases on its balance sheet, he said.

Wren said he does not expect to see the Fed reduce its asset purchases until next year. "The criteria they laid out, the unemployment rate they laid out and the inflation rate, we're still far away from either of those. We're going to see not such a great second quarter GDP. The Fed is going to be careful not to pull the punch bowl away too soon. They're going to be safe rather than sorry," he said.

At issue for markets has been whether rates have risen because of the economy improving, or just because of the Fed's talk about slowing bond purchases. Binky Chadha, Deutsche Bank chief global strategist, head of asset allocation, said the rise in the 10-year Treasury note yield, since May 2, came in two legs, and the first was because of improved economic news, in the April employment report. But it gained momentum when Fed Chairman Ben Bernanke testified before the Joint Economic Committee May 22 and said the Fed could look to start tapering its purchases in a couple of months.

Although more hawkish members of the Fed had said the same thing, markets reacted to Bernanke's comments, even though he emphasized that the economy must show sustained improvement before the Fed would slow down. Chadha notes that the Nikkei, now down more than 20 percent from its highs, peaked on that day.

"The first leg was very good for some risk assets, not all of them, not for carry, but good for equities," Chadha said. "The second leg up has been bad…Simply put it has nothing to do intrinsically with higher rates. It has to do with the unwind. The taper has to do with the ending of the easing bias of the Fed and the beginning of the end of QE, and what we're seeing is a bit of unwind of QE type trades and that has morphed into a position unwind in all asset classes."

Stocks were rattled this past week, with the S&P 500 down 1 percent at 1626, and the Dow down 1.2 percent at 15,070. The Nasdaq fell 1.3 percent to 3423, its worst week in two months. The 10-year yield hit a high of 2.23 percent this past week but was at 2.13 percent late Friday.

Chadha expects this to be a temporary downturn for stocks. "If you want to look at it from the vantage point of equities, it's a temporary blip. It's struggling hard to get a five percent down move," he said. As of Friday, the S&P was 3.6 percent off its highs.

Chadha also expects the economy to improve as the year progresses. "We're looking to the Fed for clarity. It's also unfortunate the (Bernanke) taper comments were not part of a bigger picture presentation that there is much greater confidence in growth and the sustainability of the recovery. The market has just responded to the unwind of QE without the normal positive reaction that this is in the context of growth," he said.

He said he expects the economic data to turn and start surprising positively over the summer. "If the Fed provides some clarity...the markets will come back. It's really a market event, not an economic event," he said.

While they expect market volatility to continue in the second half of the year, Wells Fargo Advisors strategists raised their target on the S&P for year end this past week, and now see it at 1650 to 1700, from 1575 to 1625. "I don't think rates are going to rise very much. I do think they could come down a bit if the Fed gives some clarity that they're not going to start to taper. We're far from normal rates even in a 2.5 percent growth environment. I do think there is some flight to quality. They're buying bonds. They're buying U.S. stocks. It's become a safe haven equity market as well," he said.

G-8 meets
8:30 am: Empire State survey
9:00 am: TIC capital flow data
10:00 am: NAHB survey

First day of FOMC meeting
8:30 am: CPI
8:30 am: Housing starts

2:00 pm: FOMC statement, projections
2:30 pm: Fed Chairman Ben Bernanke holds press briefing

8:30 am: Initial claims
8:58 am: Manufacturing PMI
10:00 am: Existing home sales
10:00 am: Philadelphia Fed survey
10:00 am: Leading indicators

This article originally appeared at CNBC.com .

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