Fed's effort to ease fears generates only more concerns
Ben Bernanke's confidence in the U.S. economy did not kill the worm of doubt that has been gnawing at markets.
Investors sold off both stocks and bonds at a record pace Wednesday and Thursday after Bernanke, the chairman of the Federal Reserve, midweek spoke about improvements in the economy that could allow the central bank to step back from its unusual monetary stimulus of the past few years.
Markets have sold off before and then quickly recovered as they digested Bernanke's words. Still, the steep market declines both days underscored the fears circulating through trading desks. One concern is that the economy is not strong enough to do without the Fed's support. Another is that the Fed's decision to ease off the gas could, in itself, cause enough turmoil in the markets that economic growth could be threatened.
"There is a tremendous amount of doubt whether without Bernanke's help, the economy can keep chugging along," said Thomas di Galoma, one of the heads of bond trading at ED&F Man Capital Markets.
Investors were still absorbing signals on Friday from the sell-off could ultimately represent nothing more than a hiccup that created buying opportunities to St. Louis Federal Reserve President James Bullard saying that he voted against the Fed decision to lay out its plans to taper bond buys because it was badly timed. The Fed should have waited "for more tangible signs" of economic improvement and a halt in the downward direction for inflation, according to Bullard.
Although the proverbial truth might fall somewhere in between, there's still no shortage of anxiety in the investment community, even if Friday provided something of a cool-down period. Two of the three big indexes advanced to close the week after the Standard & Poor's 500-stock index ended down 3.8 percent from Wednesday to Thursday its worst performance this month. The Dow Jones industrial average fell about 3.6 percent those two days, while the Nasdaq fell 3.4 percent
"Saner heads are prevailing," Jim Dunigan, chief investment officer at PNC Wealth Management, said Friday. "People are looking a little deeper into the message from the Fed the economy is getting better," he said. "At the end of the day that's a positive."
But the breadth of the angst was still evident across bond markets. Investors did not just sell the longer-dated government bonds that the Fed has been buying; they also sold shorter maturities, pointing to predictions that interest rates are likely to rise across the board. The interest rate on the benchmark 10-year Treasury note, which rises as the price declines when investors sell the bonds, climbed to 2.36 percent from 2.19 percent, the sharpest increase this month.
If rates continue to rise, it could crimp lending and eventually hurt the broader economy and stock markets.
Many strategists said the investors who sent the markets down last week were panicking and overlooking the nuances of Bernanke's words. Bernanke emphasized repeatedly that the Fed was not likely to pull back on the stimulus until it was clear the economy could handle it and could step right back in if there were signs of faltering.
"Nobody is listening," said Gennadiy Goldberg, a rates strategist at TD Securities. "As soon as you give the market anything to chew on, they are going to tear the limb off."
Like many economists, Bernanke said that it would ultimately be healthy for interest rates to rise from the unnaturally low levels of the past few years.
What the Fed is hoping to see is gradually rising interest rates alongside a continuing rally in the stock markets.
But Bernanke acknowledged that he had been caught off guard by the extent of the market's reaction to indications that the Fed might consider slowing down its asset purchases.
"We were a little puzzled by that," he said of the sharp jump in interest rates.
It is the Fed's apparent difficulty in predicting and managing the markets' reaction that represents one of the most disconcerting threats to the economic recovery. Investors could decide that Bernanke is losing his ability to influence interest rates and continue to sell bonds despite the Fed's efforts to calm the markets. A sudden surge in selling would most likely ripple violently through global markets.
"If bond traders succeed (like bond vigilantes from another era), what does that mean for the economy?" Jonathan Lewis, the chief investment officer at Samson Capital Advisors, wrote in a note to clients.
Most investors consider a disorderly market plunge to be a distant possibility, but there are more widespread concerns about the economy's ability to continue growing without the Fed's help.
Since the Fed first indicated in May that it might step back from bond purchases, investors have sold mortgage bonds and pushed up mortgage rates. The number of new mortgage applications last week fell 3.3 percent from the previous week.
Source: Mortgage Bankers Association