The Fed was the market’s primary anchor for a long time, providing it reassuring stability. But uncertainty about the Fed’s future course is threatening to remove that anchor. An end to the Fed’s monetary stimulus and normalization of interest rates will not be a bad thing for the economy in the long run, but the interim period could be very unnerving for markets that have become used to the Fed diet.
Uncertainty gives rise to volatility, which has come back in full force over the last few weeks after steadily going down this year. On roughly one-third of the days since the Fed’s last meeting on May 1, the Dow has moved more than 100 points in either direction – half the time up, half the time down. This is reflected in the CBOE’s VIX Index, the market’s so-called 'fear gauge,' which has moved up more than 30% in the last few weeks, admittedly from unusually low levels.
The Fed will move, whenever it does, in a slow and deliberate fashion. It took them years to expand their balance sheet to the current level and it will most likely take them even longer to bring it down. And the ‘taper’ debate is not even about unwinding the QE program. The Fed’s balance sheet will still be expanding after the ‘taper’ announcement, but at a slower pace than before. But markets tend to look ahead to the end point and they see the ‘taper’ as the beginning of the end for the Fed’s extraordinary monetary policy in response to the 2008 crisis.
We may not get all the clarity from next week’s FOMC meeting. But the Bernanke press conference after the meeting should provide useful directional clues. In the meantime, we better get used to these see-saw movements in the market on a day-to-day basis.