Here's a thought experiment in the wake of Wednesday's Fed meeting: what would have happened if the central bank had actually decided to do anything this week? On Wednesday the Federal Reserve's Open Market Committee announced no changes to near-zero interest rates or its asset-buying binge known as QE3. That announcement sent the stock market plummeting and treasury yields spiking late Wednesday and throughout the day Thursday.
Investors have been speculating for months about when the Federal Reserve would dial back its $85 billion monthly asset purchases, the third round of the Fed's quantitative easing stimulus program, or QE3. Since the Fed announced on Wednesday that it would keep QE3 and the near-zero federal funds rate as-is, the Dow Jones Industrial Average has fallen by over 500 points, including more than 350 on Thursday alone. Meanwhile, yields on 10-year treasuries have jumped to over 2.4 percent — a big leap from Tuesday's 2.2 percent and the 1.9 percent range seen just a month ago.
Market swings were, perhaps, to be expected. Though no change in policy was announced, Chairman Ben Bernanke did lay out the conditions for dialing back QE3, primarily if the economy continues to improve and labor markets keep their upward momentum. Still, it's not likely for these market slides to continue for long, say analysts.
"I think the increase in yields is too far. It's an overreaction," says James Marple, senior economist at TD Economics, of the giant jumps in treasury yields. The market in treasuries has gotten way ahead of itself, he adds, saying it "basically kind of pulled forward expectations for QE3 not only being tapered but completely ending."
Quantitative easing works in part by driving those yields down, which in turn means lower interest rates on things like mortgages, designed to spur investment and spending by consumers and businesses alike. It also means investors flocking to stocks, as their returns appear stronger relative to bonds, boosting that market.
That means both good and bad economic news can theoretically swing stock investors either way — bad news might signal more easing, but good news is simply good news. But stock investors also have no reason to panic just yet, says one analyst.
"Overall the Fed's somewhat more favorable stance on the economy and the trajectory of the unemployment rate should be a positive for corporate earnings and stocks," writes Wells Fargo Advisors Chief Macro Strategist Gary Thayer in an analysis of today's market swings. In addition, he adds that slow growth and low inflation should also continue to buoy stocks.
In addition, Bernanke's constant insistence that tapering will depend upon economic data, particularly the unemployment rate, could serve to temper skittish stock markets. The jobless rate remains slow to move, and the pace of job growth is only moderate — combined with low inflation, that's a recipe for more asset purchases. In addition, notes Marple, any new negative economic indicators could move bond yields back down again, closer to 2 percent
Of course, the Dow can't stay elevated forever, and bond yields will eventually push even further back upward. While Bernanke and his fellow FOMC members may truly believe that QE3 should remain in place for months to come, talking about it (and watching markets swing wildly) well ahead of time may mean that when the time does come to taper, investors won't sell off in a blind panic. By the time the Fed is ready to taper, markets may well have already priced in the shift.
"I think for the Fed at this point, there's no downside to tapering because all of the carnage has already happened," says Marple.