Virtually every segment of the fixed income, equity and commodity markets sold off viciously this afternoon on the back of the Fed statement and Chairman Ben Bernanke’s subsequent remarks. In the process, liquidity evaporated in certain places causing even more disorderly price moves.
The immediate trigger for this afternoon’s market debacle was heightened concern that the Fed intends to reduce its support of the economy, undermining the markets’ notion of the “central bank put.” And in reacting to signs that the Fed may gradually take its foot off the accelerator, markets completely brushed off repeated efforts by Chairman Bernanke to link ever more precisely the process of tapering to specific progress on the unemployment and inflation fronts.
Given that this afternoon’s market reaction was basically a repeat of what occurred a few weeks ago in response to initial talk on Fed tapering, many will assume that the Fed took a calculated risk in refusing to walk back from earlier such talk.
Such a Fed approach would makes sense if officials are highly confident of two factors and wish to act on a third consideration:
- that growth and jobs dynamics are firmly improving, and will do even better in the future;
- that inflation and inflationary expectations will converge upward towards the 2% target, and do so in a gradual fashion; and
- that it is now time to try to take some air out of the excessive risk taking balloon, and that this can be done in an orderly fashion.
Markets will now adjust to a new negative shock to the trio of the liquidity, risk and term premia. Heightened volatility will also fuel even greater risk aversion, including lower appetite for inventory buildup among brokers and greater cross-over investor migration back to home base.
Expect further market volatility and liquidity dislocations in the immediate period ahead. The subsequent return of market stability would be influenced by the willingness of underexposed balance sheets to go long interest rate, credit and equity risk (which is likely to be limited in the very short-term) and/or calming words from the Fed (unlikely to materialise so soon after a combined FOMC statement and press conference, especially given mounting concerns about the Fed’s credibility and effectiveness).
Most importantly, markets and the Fed are now even more highly dependent on sustained evidence that the real economy is indeed on a solid improving trends, including a consequential rise in actual and expected nominal GDP growth. With that, the focus will now shift firmly to the forthcoming June jobs report; and it will be even more intensive than usual.
Business Insider Emails & Alerts
Site highlights each day to your inbox.