How The Fed Made The Markets Tank

Markets have calmed down since the spasmic trading from a couple of weeks ago, when Ben Bernanke's "taper" talk sent interest rates spiking, and stocks diving.

Still, there's a lot of talk about what exactly happened, and what it all meant.

In an email blast to clients this weekend, SocGen's Kit Juckes summarized the debate and discussion:

 The weekend press has seen a caravanserai of commentators question either the markets' understanding of what Ben said, or Ben's understanding of markets, or both. Gavyn Davies, Paul Krugman, Phillip Coggan, the Guardian, the FT, and more. The basic line is that markets over-reacted and the Fed needs to be careful. And despite one of the aforementioned having a Nobel prize in economics, I mostly disagree with the interpretation.  I may only be a fool on a hill, but if markets go a bit crazy when the Fed merely invites us to imagine what might happen if they stop buying bonds, I think that is rock solid evidence of over-correlated positions. The Fed is right to try and let some air out of the balloon. Back off now, and we'll really be in trouble.

The best explanation for what happened comes from Felix Salmon, who notes that the "taper" is just the McGuffin, and that the real story is what's happening in the Fed Funds Futures market, which, post-Bernanke, has really moved up its date for expectations of the first rate hike.

This chart comes from Goldman Sachs:

Goldman Sachs

Says Felix:

Put another way, you and I and Ben Bernanke might think that QE works because when you drop money from helicopters and that money is used to buy bonds and take them out of circulation, the price of those bonds goes up and their yield goes down. But in fact, the main reason that yields fell has nothing to do with the mechanistic consequences of buying bonds — as generations of investors have found out, buying up assets generally has only a very short-term and modest effect on the price of those assets.

Rather, QE turns out to be a surprisingly effective way of signalling to the market that rates are going to stay at zero for a very long time. And when you say that QE isn’t likely to stay in place much longer, the market takes that as tantamount to saying that rates are not going to stay at zero for nearly as long as they had thought.

This is the story.

People see the "taper" as a signal of a rate hike not that far behind it. The Fed has tried to dissuade people from that notion (through the press and through speeches) but that's why the market got worked over.

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