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.
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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.