Anticipation
Financial markets strive to anticipate changes, whether in economic policy, macroeconomic developments, or corporate earnings. So it was today as Fed Chairman Bernanke testified in front of the Senate/House Joint Economic Committee.
The especially acute challenge for market participants today, in listening to the testimony, was to discern the likely course of America's highly stimulative monetary policy. The Fed is currently making $85 billion in bond purchases every month (the so-called program of quantitative easing) to foster low long-term interest rates, thus encouraging lending to spur economic recovery. Though a number of economic indicators have improved, the U.S. economy is not yet registering growth at rates sufficient to lower significantly the still high 7.5 per cent rate of unemployment (despite consistent falls in recent months). And deflationary pressures (like those that have led to long-term stagnation in Japan) remain.
Thus, in today's address, Bernanke warned that a change in policy now would "carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further". On these words, the markets jumped - relieved that a tightening of monetary policy was not imminent - with the Dow industrial average rising late morning by as much as 155 points, and the 10-year government bond yield dropping below 2%. But then, Mr. Bernanke spoke further, in a question-and-answer period with Congressional committee members, suggesting that a tapering of the bond-purchasing program could be decided over the next few Fed meetings, if the job market shows "real and sustainable progress". And he wouldn't rule out curtailing the purchases by Labor Day. On these words, markets began to reverse course.
Then, shortly after the testimony, minutes of the previous Fed meeting were released, indicating a willingness of "a number" of members to scale back quantitative easing, perhaps as early as June. This news served to accelerate the market reversal, such that a 155 point rise in the Dow turned into a rout of as much as 120 points by mid-afternoon, finally closing down some 80 points.
Traders have an expression - "don't play on days when the Fed sneezes". This was certainly true today. But, all this seesawing leaves us with little, if any, better idea of when monetary tapering might start - indeed, the latest minutes make it apparent that Fed members themselves are sharply divided on the timing. The same can be said of the future direction of fiscal policy - will Washington ever address entitlement spending, or the byzantine, distorting tax code? Markets would do well to pay far less attention to the vagaries and in some cases ineptitude of policy-makers, and focus instead on economic fundamentals and corporate earnings.