Now and Then: Fed Policy Changes Turn Markets on Their Head

Stock Market

Source: http://www.flickr.com/photos/teegardin/

The U.S. Federal Reserve surprised markets on Wednesday by announcing that it was not tapering asset purchases, and would continue buying agency mortgage-backed securities and longer-term securities at a rate of $85 billion per month. The news undermined months of speculation and a consensus among economists and investors that the Fed would announce some degree of tapering, and tripped up Mr. Market’s bad-news-bears attitude on Wednesday.

For some context, Mr. Market has grown so accustom to accommodative monetary policy that even the specter of its withdrawal has sent shock waves through various asset classes around the world. Investors have grown used to all the side effects of quantitative easing: higher equity valuations, lower interest rates, higher inflation expectations, and a weaker dollar.

A change in the rate of asset purchases would mean a change in market conditions, and with its usual, awkward prescience, the markets priced in the anticipated policy shift over the past few months.

So what happens when the markets expect the Fed to ease up on the gas, and it doesn’t? Taper talk really started heating up in May. From the beginning of that month through the middle of September, equities pretty much mimed the outline of a roller coaster. The S&P 500 ended the period between May 1 and September 17 up about 7.7 percent, but not without experiencing the deep ups and downs attributable to uncertainty and a changing environment. At the same time, interest rates climbed nearly a full percentage point, as indicated by the yield on the 10-year Treasury note.

But on Wednesday, the Fed shattered market expectations. Without a tapering announcement, equities spiked to fresh highs and the yield on the 10-year Treasury fell from 2.853 percent to 2.708 percent.

Dow Jones Industrial Average Index Chart - Yahoo! Finance

Markets reacting dramatically to changes in Fed policy is hardly anything new. Just this year, the mere notion that the Fed would taper sent markets down 5.8 percent in June and 4.6 percent in August in what many have called “taper tantrums.”

S&P 500 Index Chart - Yahoo! Finance

But these tantrums pale in comparison to the fits Mr. Market threw in March of 2010 and June of 2011 when the Fed ended its first two rounds of quantitative easing. Equities fell by as much as 10 percent when the Fed ended monetary stimulus abruptly and traders were forced to react dramatically in order to adjust to the new environment.

222

Don’t Miss: Dodd-Frank Tests Show BofA Can Survive Prolonged Stress.

More from The Cheat Sheet