What's next? Fed delay both delights and confuses market

Wall Street’s knee-jerk reaction to the Federal Reserve choosing to keep the pedal to the monetary policy metal was loud and clear on Wednesday: Buy Buy Buy!

That initial exuberance, however, masks a nagging worry and no shortage of confusion about the Fed’s reluctance to act after the central bank had positioned markets for a reduction in its $85 billion per month bond buying program. It left many investors in a fog about what comes next.

The trading day certainly did not unfold as expected. The vast majority of investors were bracing for a modest reduction in the Fed’s monthly purchases of U.S. Treasury debt and mortgage bonds.

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But citing concerns about low inflation, the impact of a recent rise in long-term interest rates on housing, and headwinds from Washington’s “fiscal retrenchment,” the Fed said it needed to see more economic improvement before acting.

The Fed’s refusal to start to bow out of the asset-buying game sent stocks soaring, with the benchmark U.S. S&P 500 index closing at a record high.

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“The Fed is sending a message that the economy is weak, and that’s confusing,” said Wayne Kaufman, chief market analyst at Rockwell Securities. “I would’ve been happier if there had been a small taper to prepare the investing public to the idea.”

Fed Chairman Ben Bernanke first suggested in May that the central bank could pull back on its bond purchases late this year if economic growth continued to gain traction, as he predicted it would in the second half of this year and in 2014.

That caught markets flat-footed in the spring and pushed up bond yields and mortgage rates by more than a percentage point over three months, slowing momentum in the U.S. housing market recovery.

The benchmark 10-year U.S. Treasury yield, which began May trading as low as 1.61 percent, hit a two-year high this month just above 3.0 percent, before falling back to 2.69 percent on Wednesday.

That “tightening of financial conditions” over the summer could, if sustained, slow improvement in the economy and the labor market, the Fed said on Wednesday.

It likely influenced policymakers’ decision to cut their 2013 growth forecast to 2.0 percent to 2.3 percent from a June estimate of 2.3 percent to 2.6 percent, the biggest drop in the near-term forecast in more than a year. Some on the Fed’s policy committee thought 2013 growth could be as low as 1.8 percent.

The Fed is clearly telling markets that “the economy isn’t as strong as we’d like,” said David Joy, chief market strategist at Ameriprise Financial, “which has implications for corporate earnings down the road.”

MIXED MESSAGES

Economists polled by Reuters recently forecast the economy would grow at a 2.5 percent rate this year and 3.0 percent by the end of 2014.

That helps explain why investors erroneously bet on the Fed to begin “tapering” its bond purchases this month, said Douglas Borthwick, managing director at Chapdelaine Foreign Exchange. He was among the minority who thought the Fed would wait.

“The Fed has always said they were data-dependent. But the data over the past month hasn’t been good,” he said.

“We have yet to see the U.S. economy move at a pace that would let the Fed take the crutches away,” he added. “Crutches won’t fix a broken leg but they do help you to walk, and right now, (the bond purchases) are still the economy’s crutches.”

That’s not terribly comforting for bond investors who took the Fed’s cue and bet on a tapering this month.

Mary Beth Fisher, head of U.S. interest rate strategy at Societe Generale, took particular issue with the reference to tighter financial conditions hurting economic growth.

“Um, really? Multiple FOMC members have been preaching for months that tapering is not tightening, right? It’s simply a reduction of extraordinary accommodation,” she wrote in a note to clients.

With Fed Vice Chairman Janet Yellen seen as the front-runner to replace chairman Bernanke if he steps down as expected early next year, she said markets are confused about who is calling the shots.

“Where do we go from here,” she asked. “To the bar for a gin and tonic, and a long, slow consideration of just how dovish this new Federal Open Market Committee will be given the torch passing that appears to have occurred at this meeting.”

Jeffrey Gundlach, chief executive at DoubleLine Capital in Los Angeles, said the Fed has only itself to blame for prematurely signaling a pullback and sparking a worrisome rise in rates.

“The Fed botched its message in June and is trying to undo that mistake. The data does not suggest that the economy can make it on its own,” he said, adding that once the Fed begins tapering purchases, reversing course becomes tricky.

FISCAL FOLLIES

To be fair, some pointed out that Congress has made life difficult for the Fed by hitting the economy with government spending cuts and higher taxes earlier this year.

Now, the prospect of a government shutdown next month if Congress can’t agree on a new budget and a rise in the debt ceiling in coming weeks is raising new concerns.

In a news conference after Wednesday’s announcement, Bernanke said failure to raise the debt ceiling or keep the government open “could have very serious consequences for the financial markets and for the economy, and the Federal Reserve’s policy is to do whatever we can to keep the economy on course.”

“I think the Fed is very concerned about the potential for political dysfunction and to start withdrawing stimulus now might be to put something back in the bag that they may need in literally a couple of weeks,” said Brad McMillan, chief investment officer at Commonwealth Financial in Waltham, Massachusetts.

And that leaves investors wrestling with whether to be happy or worried.

On one hand, “people are going to say, ‘Hey, great, the Fed is back in the game, they’ve still got our backs,’” said McMillan. But “from a real economy standpoint, what (this decision) says is the Fed is more nervous about the economy than generally perceived.

Reuters