When Federal Reserve policymakers sat down in Washington a week ago to discuss ratcheting back the central bank's $85bn monthly program of buying fixed income securities, investors and traders figured they knew what was coming next. Indeed, they were so confident that most had already prepared their portfolios for what they thought would follow.
As it turns out, Fed Chairman Ben Bernanke doesn't think that the US economy is ready to stagger along without the central bank's support just yet.
The Fed has burdened the bulk of market stimulus for the past three years. Three successive rounds of quantitative easing (QE) have left the Fed with more than $3tn on its balance sheet – up from about $800bn before the crisis. Bernanke would clearly love to taper off the flow.
Still, Bernanke has said he thinks the economic outlook is just too uncertain to even begin dismantling QE3, which wags have dubbed "QE-infinity" due to its open-ended nature.
For regular investors – people with money in mutual funds – all the talk about QE seems distant.
So just what is QE, and why does it matter?
It comes down to interest rates. Central banks believe that low interest rates keep money moving through the economy. Low rates can spur lending and encourage more consumption. The Fed can cut interest rates it charges banks, but for a long time it couldn't force those banks to pass on low rates to consumers.
Enter QE, a program through which the Fed buys two kinds of bonds: government-backed mortgage bonds, and treasury bonds. Because they're backed by the government, those are bonds that Wall Street calls "safe havens", which means that investors like to buy them when the rest of the world looks scary. After the housing bust, when the markets looked terrifying, investors loaded up on mortgages and treasuries.
QE changed the mix. By buying the mortgage and treasury bonds itself, the Fed became a player on the market, and encouraged everyone holding mortgage and treasury bonds to sell their holdings to the Fed – the biggest buyer in town. That, in turn, would force investors to buy other bonds, like those of companies, or invest more money in the stock market.
The result: the Fed was able to keep capital flowing, stimulate lending activity that might otherwise not take place – thus supporting economic growth – and prod investors to take more risk themselves. The "safe havens" were no longer so profitable.
That's the purpose of QE: when low interest rates alone aren't enough to jump-start a struggling economy, central banks can use quantitative easing as a kind of last-ditch boost to the economy.
Ending QE, then, makes markets nervous. Can they cut it on their own? What will the world look like without the Fed's support? That's why stock and bond markets have been bumpy since late May, when Bernanke first speculated publicly about the possibility of a taper.
One of the consequences of a reduction in quantitative easing is the prospect of higher interest rates, which was enough to convince investors to reduce their bond holdings. Bond yields – which move in the opposite direction to prices – rose throughout the summer.
Meanwhile, the stock market rally faltered:higher interest rates tend to make stocks relatively less attractive, and investors opted to "take some profits". In other words, they started selling their holdings.
One way or another, investors tweaked their portfolios to prepare for the change Bernanke had all but promised.
Except he hadn't promised it.
What followed the Fed's announcement that QE would continue is a sharp reminder of what happens when everybody bets big on one side of the market.
Imagine, if you will, that everyone on a boat has gathered on its starboard side, perhaps to gawk at a landmark like the Statue of Liberty. Then the captain announces that there's an engine room fire and that passengers will have to abandon ship via the lifeboats located on the opposite side of the vessel. Imagine the frantic dash from one side to the other. Now you've got a good idea of the frenzied trading responsible for the outsize rally in stocks, bonds, gold and other assets in the 24 hours following the Fed's announcement.
But just as emotion drove those hypothetical passengers to scramble from starboard to port, so emotion – in the form of the traditional blend of greed and fear – has been driving stocks and bonds since the Fed's announcement.
"The punchbowl will stay full for a while longer," says Leo Grohowski, chief investment officer at BNY Mellon Wealth Management, explaining the exuberant initial reaction.
Still, investors are wary of dipping too freely into that punchbowl. The volatility of the last few months reminds us of the dangers of becoming intoxicated by the Fed's pledge of easy QE money.
And indeed, sober second thoughts came swiftly, resulting in a stock market sell-off on Friday substantial enough to wipe out all the its earlier gains.
Instead of concentrating on the "what" (the continuing stimulus) some are already asking "why" and "what next": why does the economy still look wobbly; and what happens when quantitative easing is eventually tapered off, as looks highly probable.
This doesn't mean that some of the assets that rallied last week didn't deserve their gains. Some money managers, for instance, suggest investors have been overly bearish (ie negative) on the outlook for emerging markets.
Compared to US stocks, shared companies in emerging markets like China and India now look (in aggregate, at least) significantly cheaper, says Todd Millay, managing director of Choate Investment Advisors in Boston. But he warns against trying to buy them – or any other asset class – in an emotion-driven market.
"These quick rallies and quick sell-offs show that market timing doesn't work," says Millay, who oversees $4bn for wealthy investors. "You can't wait on the sidelines until you're sure what will happen next. "
When everyone else around you is bouncing from one emotional extreme to another, the odds are much higher that you'll make a wrong decision, or that your timing will be off. With a big question mark hovering over the Fed's intentions with respect to interest rates – one of the most significant factors shaping investment returns – markets are likely to remain volatile and emotional for the rest of the year. You don't want to end up with financial whiplash.