Markets, investors on edge as Fed prepares to shift gears
Fears that the Fed is about to reduce its stimulus helped send stock, bond and currency prices on a wild ride this week, with Japanese stocks experiencing their worst one-day decline since the 2011 tsunami.
Around the world, traders debated the significance of the statement made on Wednesday by the Fed's chairman, Ben Bernanke, that a change of the central bank's policy could come soon.
The sweeping stimulus programs initiated by Dr Bernanke have helped feed a four-year rally in US stock prices and inspired other central banks to follow suit.
But even fans of the Fed's efforts have said that the size and scope of the stimulus make it hard to know what will happen once the Fed takes its foot off the gas, paving the way for unanticipated consequences and market volatility.
"There are no neat answers, because we've never been in this situation before," said Marshall Front, co-founder of money manager Front Barnett Associates.
Fed officials are well aware of the confusion that lies in store and have emphasised that any changes are still some way off and likely to be carried out slowly.
After Dr Bernanke's appearance before Congress, the president of the St Louis Federal Reserve Bank, James Bullard, said in a speech in London that even after the central bank slowed down monetary stimulus, policy makers could step in again if the economy showed signs of faltering.
Speculation that the Fed would slow its monthly purchases of government bonds has been growing for months. Investors have known that the central bank's efforts could not continue forever, and many asset managers have begun to prepare their portfolios for the day when the Fed pulls back.
Front Barnett has sold all of its long-term bonds to reduce exposure to changes in interest rates, and it no longer holds any Treasury bonds. In a more optimistic vein, the firm has been shifting money into riskier stocks on the assumption that rising interest rates will be accompanied by growing economies.
When the Fed does shift gears, the process will begin with a slow tapering of bond purchases. Even that will begin only if the US labour market grows stronger and unemployment falls further.
US economic data on Thursday showed slight signs of improvement. The number of people filing for unemployment benefits last week was 340,000, lower than the week before. And new home sales rose to the highest level since 2010.
The US housing market has been one of the biggest beneficiaries of the Fed's purchases of government and mortgage-backed bonds. When it slows mortgage rates could rise, a new drag on the housing market.
How investors respond to the Fed's policy will determine how the US economy is affected. That will be hard to predict even for the smart minds at the Fed, said William O'Donnell, the head of Treasury bond strategy at RBS Securities.
"We've supported the Fed's actions for a long time," Mr O'Donnell said, "but we've long harboured fears that the exit is likely to be messy with lots of unintended consequences."
The harshest critics of the Fed are worried that a change in policy could pop what some believe to be a bubble in stock prices.
Peter Andersen, a portfolio manager at Congress Asset Management, has been buying growth-oriented stocks in preparation for another rise in the market.
He said the Fed was likely to let interest rates rise only if the economy was improving, which would in turn help stocks.
Whatever the uncertainty in the US, the picture is even murkier overseas.
The Japanese government, which has been trying to follow the Fed's lead in stimulating its own economy, had a setback on Thursday with the Nikkei plummeting.
The drop marked a sharp reversal for a market that has been one of the world's best performers this year, thanks to the energising effect of Prime Minister Shinzo Abe's economic shock therapy.
There was disagreement about what had caused the dive. The Fed took some of the blame, as did the release of weak data on China's manufacturing sector.
Frequently Asked Questions about this Article…
Bernanke said a change in Fed policy could come soon, which stoked fears that the central bank might slow its huge stimulus program. That prospect sent stocks, bonds and currencies on a wild ride as traders debated the timing and likely market impact of any reduction in support.
Tapering means the Fed would slowly reduce its monthly purchases of government and mortgage-backed bonds. The article says any tapering would begin only if the US labour market strengthens and unemployment falls further, and even then the process is expected to be gradual.
A pullback in Fed buying could put upward pressure on interest rates and push down long-term bond prices. Some managers in the article sold long-term bonds to reduce rate exposure, while others shifted into riskier, growth-oriented stocks on the view that rising rates would come with a stronger economy. The transition could also create volatility and unintended consequences.
The article reports some firms, like Front Barnett, have sold long-term bonds to reduce rate exposure, but it also highlights widespread uncertainty about the Fed's exit and the likelihood of a slow, cautious taper. That means reactions vary among managers — the piece describes actions others are taking but does not present a one-size-fits-all recommendation.
Yes. The article notes the US housing market has been a major beneficiary of the Fed's bond purchases, and if those purchases are slowed mortgage rates could rise, creating a new drag on the housing market.
According to the article, the Fed is focused on labour-market strength. Recent signs mentioned include a drop in weekly jobless claims and a rise in new home sales, and officials have indicated they want to see continued improvement in employment before tapering bond purchases.
Markets around the world were rattled: the article cites a severe one-day plunge in Japanese stocks (the Nikkei) — the worst since the 2011 tsunami — and notes that weak Chinese manufacturing data also contributed to the sell-off, illustrating how Fed moves can ripple through global markets.
The article gives examples: Front Barnett sold its long-term bonds and shifted money into riskier stocks on the assumption that rising rates will accompany stronger growth, while Peter Andersen of Congress Asset Management has been buying growth-oriented stocks expecting improvements in the economy. It also notes Fed officials have warned they could resume support if the economy falters.
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