U-turn leaves investors in a fog

While central bank's delay in reducing its bond purchases triggers a rally in stock markets, it sends a message that the economy is still weak

PUBLISHED : Friday, 20 September, 2013, 12:00am
UPDATED : Friday, 20 September, 2013, 1:02pm

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 US$85 billion-per-month bond-buying programme. It left many investors in a fog about what comes next.

The trading day certainly did not unfold as expected. Most investors were bracing for a modest reduction in the Fed's monthly purchases of US Treasury debt and mortgage bonds.

Right now, [the bond purchases] are still the economy’s crutches

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 S&P 500 Index closing at a record high.

"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 recovery of the US housing market.

The benchmark 10-year US Treasury yield, which began May trading as low as 1.61 per cent, hit a two-year high this month just above 3 per cent, before falling back to 2.69 per cent on Wednesday.

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

It likely influenced policymakers' decision to cut their 2013 growth forecast to 2 to 2.3 per cent from a June estimate of 2.3 to 2.6 per cent, the biggest drop in the near-term forecast in more than a year. Some on the Fed's policy committee thought growth could be as low as 1.8 per cent.

The Fed was 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".

Economists recently forecast the economy would grow at a 2.5 per cent rate this year and 3 per cent by the end of 2014.

That helped 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 US economy move at a pace that would let the Fed take the crutches away. 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."