Volatility has returned. Confusion over when and how the Fed will end it's QE has become a parlor game on Wall Street.
Diane Swonk, chief economist at Mesirow Financial had what I think was the most rational comment of the week when she noted, “taper does not equal reversing policy.”
Bernanke has not only indicated as much but the Fed has already indicated exactly how their QE exit would occur. Whether or not they can do so with such precision is a completely different question.
For now, we're in a Goldilocks environment: the economic news is good, but not so good that the Fed is worried about slamming on the brakes just yet. Economist Ed Yardeni was quoted last week saying “the stock market is open-minded to the idea that they (the Fed) may be able to make a smooth transition if the economy continues to perform better.”
To date, the Fed has communicated its intentions extremely clearly, and there is every reason to believe that when the taper and the ultimate exit begin, Bernanke will let the world know each and every move.
All that said, last week's action suggests that the bond market is jittery. Some of the significant outflows in high yield and mortgage-backed securities can be chalked up to traders finally realizing large unrealized gains, but I'd assume a chunk of the selling is coming from trigger-happy investors who, still smarting from portfolio losses during the financial crisis, are concerned that they'll be too late to the selling party.
If the Fed is true to its word, and if we're reading the economic tea leaves correctly, it seems that the market is overestimating the velocity of rates moving to higher levels. As Gary Cohn, COO of Goldman said last week, “When you get a fundamental shift in rates, which doesn't happen very often, the initial move is always pretty dramatic…people try to get ahead of it.”
His partner Gary Beinner, CIO of fixed income at GS noted “the magnitude of the moves was extreme and wasn't based on fundamentals. It may have been based on a liquidity-driven event, with hedge funds selling when prices fell to target levels.”
Finally, Beinner commented that he thinks merging market debt is still cheap and that investors should also look to floating rate corporate bonds. I agree, thanks to low cost and liquid exchange-traded funds (ETFs), these investments are avialable to everyone.
This market volatility may continue, but worrying about whether or not the Fed is going to “taper” anytime soon is a sport best left to professional investors. For the rest of us, if we continue to maintain a diversified portfolio of all types of stocks and bonds and keep our eyes on the long-term, we'll achieve our financial goals.