A first step in treating post-traumatic stress disorder is to compile a “hierarchy of fears” to be surmounted, from the least scary to most terrifying. Investors have undergone their share of financial trauma over the past five years, and remain twitchy with flashbacks. In the past month, especially, alternating and confusingly contradictory worries have come as world stock and bond markets struggle to assess potential threats.
There are two principal Big Fears, which have waxed and waned in various combinations this year.
First, that global economic growth – already negative in Europe, slowing in China and sagging in most emerging economies – will weaken further. The second is the worry that the Federal Reserve will soon curtail its volume of “quantitative easing” asset purchases, diminishing one force – both perceived and actual – compressing interest rates and supporting financial markets.
Here, in order from least to most scary, is how the various investor fear pairings stack up, along with a word about what exactly investors should be most afraid of:
Too much of a good thing. Not so scary at all. Until markets get bubbly and pop, this is the heads-I-win-tails-you-lose scenario in which the U.S. economy is seen to be accelerating at the same time the Fed is firmly committed to continuing its extreme easing efforts. This is largely what prevailed in the earlier months of this year, when stocks were levitating, Treasury bond yields were compressed and corporate-junk bond rates sank to record lows.
One way of looking at this condition is that the Fed’s medication for a convalescing economy – $85 billion of bond buying a month – was not thought to be needed as badly, and the drugs were increasingly being used recreationally.
Fed officials did not want overconfident financial markets to continue barreling higher and under-pricing risk, so they began sending signals that their intentions for QE were unclear. The Fed dreads a situation in which bubbly stock and bond markets demand a major tightening move to fight excessive speculation before the real economy is “ready” and on a sturdy trend of job growth.
In a calculated February speech, Fed governor Jeremy Stein pointedly noted “a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit,” a coded warning that investors should not get too comfortable in thinking markets could only strengthen.
That overconfidence has been clipped back. Economic numbers have softened – especially in the rest of the world – and the Fed’s eventual cutback on QE has investors’ attention.
Stronger economy, Fed "tapering." This is probably most professional investors’ baseline expectation, justified to some degree by Fed rhetoric. The decent-to-good job numbers the past two months, and firmer housing and auto markets appear to put the domestic economy on the expected pace of improvement, leaving Wall Street to handicap the ballyhooed “tapering” of QE, perhaps later this year.
While it seems frightening to the extent one believes the markets have largely (or to some, entirely) been lifted by central-bank policy, after a nervous adjustment period it would probably be among the better outcomes. Less Fed help for the “right” reasons, accompanied by moderately higher interest rates, should be palatable if the economy holds together.
Economic downturn, steady Fed. Obviously, this is the opposite of the above scenario. It’s probably a bit underappreciated as a risk, but could be treacherous even with a still-generous Fed. Profit margins are elevated, stocks are not demonstrably cheap, and an unexpected “growth scare” would leave the market vulnerable to at least a nasty correction.
The prospect of another downward wiggle in the economy is exactly why the Fed will not be pre-emptive in “tapering.” Fed officials are fixated on the “fiscal drag” of lower federal spending and are also agonizing over how to stage-manage any reduced QE so markets don’t instantly extrapolate "less" all the way to "zero." Of course, Bill Gross of Pimco brings up another wrinkle, suggesting on Yahoo! Finance's Daily Ticker that Fed tapering might become necessary simply because lower deficits will mean a shortage of Treasuries.
Some sort of "financial accident." The combination of plentiful cheap money, crowded macro trades, leverage, an emerging-market bust and policy confusion is combustible. These things can’t be predicted easily, but the increasingly worrisome action in emerging economies and jumpy world markets – with their familiar rhythms and correlations disrupted – fed the sharp, brief financial panics of the late 1990s.
Alarmism helps no one, and the U.S. stock market has served as something of a global safe haven as these threats have mounted. But such a scenario seems more worth the worry than the chance of a well-telegraphed dialing-down of the money flow from a still-generous Fed that sees things getting better.
Central banks ultimately prove impotent. This is a daunting possibility, one that at least has been hinted at in the way markets have reacted to signs that policy makers can’t, or won’t, stoke more growth and pacify markets.
Tuesday’s messy selloff in Japanese stocks and bonds after the Bank of Japan took no specific action to damp volatility in the government-debt market there suggests an acute sensitivity to signals about central bankers’ commitment and ability to implement stimulus in an orderly way.
Mary Catherine Sinclair of Strategas Research asks in a new report whether easier monetary policy is “being ‘crowded out’ by the sheer prevalence of it globally. It is just one tool at policymakers’ disposal and much of the power from it might already be gone.” Some 21 central banks globally have eased this year, after 28 did last year to stem disinflation and recharge growth.
While it’s not yet possible to declare this is going on for sure, perhaps the ultimate terrifying prospect would come if the Fed effectively says, “We’ve done what we can,” reduces QE despite limp inflationary pressure and leaves the economy on its own before it’s clear it can sustain a decent expansion.
This is far from the likeliest narrative, at least not for this year. Yet if it were to appear more probable, it would prompt cold night-sweats among the investor class. A Fed backing away in resignation – or so as not to seem entirely powerless to accelerate growth – and essentially reloading ammunition for a future downturn would not be friendly to risky assets.