The Reformed Broker makes the following point about the markets:
Should rates get totally out of control, the Fed will come right back in
and swamp the bond market with cash. Should stocks pick up more steam
to the downside, Treasurys will get a bid out of fear and this will halt
the fear over rising rates (because rates will come down as a result of
the panic buying). To some extent then, this will be a self-correcting spiral in the end, even if it is an unpleasant one.
This is a very well-articulated point that deserves further development and explanation.
The Fed has influenced a number of market aspects. Perhaps more importantly is the impact on market psychology, as traders knew the Fed was on their side and was attempting to have a positive impact on the economy as a whole. It is difficult to understate the importance of this effect; when the market had fallen out of bed, it literally got brokers back in the game willing to take on risk when the economy was weak. As the market rose, this effect did not wear off; in fact, it increased as the Fed upped its game, adding programs as they saw fit. And finally, the public communication of hard targets for their interest rate decision (the 6.5% unemployment, 2.5% inflation factors) have had the effect of putting their foot on the market's gas pedal.
These support programs have become a fundamental component of market psychology for the last 3-4 years. In the economic world, that's a hell of a long time. More importantly, we can look at this time period with an asterisk, reminding us the market's rise was aided by a Fed that was literally doing everything it could and then some to help the economy. Asset purchases are hardly part and parcel of standard Fed policy; they only occur when the Fed is trying to keep the economy out of the economic abyss. But these programs have altered the psychological make-up of market participants in a very atypical way. As a way of explaining it, imagine starting the semester with a professor telling you the lowest grade you'll get is a "B." It's an action that simply changes the way you view things in a very fundamental way.
Regardless of whether you agree or disagree with the Fed's decision (and I strongly agree with it), there is no mistaking that we now have a fundamentally different market environment. The biggest effect is on the bond market, which has had a permanent bid for the last three years, which in turn has kept yields low. The stock market has also had a profound rally from these programs. And the dollar has been weaker -- although it has hardly crashed as some commentators speculated. All of these markets will now readjust to a new reality -- one potentially without the Fed helping it along.
But Josh makes a key point; there seems to be an assumption that if things go to hell the Fed will simply say, "we told you we were backing off now; go it without us." That's not the case. If the economic and market fundamentals really start to deteriorate, the Fed will jump back in the market with something. Bernanke has already said as much in his statements. The question, or course, is when that will happen. Frankly, I don't think Bernanke knows at this point. But the possibility is always there.
