The taper is on, and the markets love it.
The Federal Reserve decided to slow the rate of its bond-buying program to $75 billion a month, from the current $85 billion. For much of the year, any hint that the Fed would begin to close the valve on its firehose of new money has led stocks and other financial assets to plummet in value. Investors have been fearful that in a world less awash in Fed-created dollars, financial markets will take a fall.
That's why Wednesday afternoon's market reaction is startling. Here is the Standard & Poor's 500 chart for the day:
As it shows, when the news of the taper first hit newswires at precisely 2 p.m., there was an almost instant drop in stock prices, as one would expect. But within a minute the market had rebounded, soaring to new heights. As of 4 p.m. the S&P was up 1.5 percent. Other markets, ranging from Treasury bonds to oil, showed a similar pattern, moving the way they normally do on a "good news" day.
Why are markets so buoyant as the Fed take its first baby step toward tighter monetary policy?
The most clear-cut explanation is this: The $10 billion taper was accompanied by steps to reassure markets that Uncle Ben (or Aunt Janet) are going to keep flooding the economy with cash, taper notwithstanding. In its policy statement, the Fed said that it will continue buying bonds and will "employ other policy tools as appropriate" until the job market has "improved substantially."
That was accompanied by a wee hint of a step in a dovish direction: In projections released in September, three of the Fed's 17 policymakers thought that interest rate hikes would be warranted in 2014. That number fell to two in December, and the number who thought rate hikes would wait until 2016 rose from two to three. (Then and now, 12 of the 17 policymakers thought that rate hikes would be appropriate in 2015.)
Add those two things up, and it points to the Fed keeping on the accelerator to encourage growth even as the bond-buying program winds down, which Bernanke said in his news conference would likely be toward the end of 2014.
As of Wednesday afternoon following the meeting, the futures market priced in only an 11.2 percent chance that the Fed will have raised interest rates by the end of next year. That was identical to the level on Tuesday, and way, way down from the 44 percent odds of a 2014 rate hike that were priced in before the Fed's September meeting.
In other words, this is a victory for Fed communications. It has taken six concerted months of effort, but the central bank has finally persuaded markets that tapering doesn't mean tightening.
There may be a second dimension in play, as well, though this one is harder to prove. After months of hype and speculation around the Fed's tapering plans, investors may just like the fact that they've gotten going with it already. In other words, the sheer fact that the Fed has been in a will-they-or-won't-they period of Hamlet-like indecision over tapering may have been holding markets back by increasing uncertainty.
Here's an interesting piece of evidence for this theory: the intraday graph of the Vix, a measure of expected stock market volatility
It fell sharply on the taper news. That's a hint that while investors may not like tighter monetary policy, they do like that Ben Bernanke & Company decided to just get it over with.