For the Markets, Fed Stimulus Has Become Yesterday's News

Concerns over sovereign debt have crashed the Federal Reserve's party, turning attention from the central bank's monetary easing efforts to the issue that helped send markets into their summer slump.

A trader at the New York Stock Exchange.
Photo: Oliver Quillia for
A trader at the New York Stock Exchange.

Problems financing debt in Ireland, Portugal and various other parts of the European Union couldn't have come at a worse time for the Fed. Chairman Ben Bernanke has led efforts to buy up Treasurys, push down interest rates and turn investors to riskier asset classes, particularly stocks.

The market had rallied to its highest point since the fall of Lehman Brothers, but in the past two weeks has retreated amid fears that Europe's troubles could infect broad swaths of the global economy, including the US. Sovereign debt issues had the same effect on the markets in mid-April, when stocks were at their previous peak.

This wasn't the way it was supposed to work for the Fed's eight-month program to buy $600 billion worth of Treasurys, part of a policy known as the second leg of quantitative easing, or QE2.

"The focus has shifted from QE2, which the market was a little schizophrenic about to begin with," says Brian Gendreau, chief market strategist at Financial Network in El Segundo, Calif. "QE2 was supposed to send the dollar down. Instead it's going up. Interest rates were supposed to go down. Instead they've gone up."

Indeed, yields on the Treasury's 10-year note and 30-year bondhave gained more than a quarter percentage point each since the Fed's announcement on Nov. 3. The yields are closely tied to lending rates, which the Fed had hoped would go down and push investors into buying riskier assets outside of Treasurys.

Stocks also have fallen, dropping more than 3.5 percent in the same time frame as the Fed's program has come under intense criticism from both ends of the spectrum—either for being too little to make a difference or posing a longer-term inflation risk as liquidity continues to flood balance sheets but not make its way into the economy.

Strategists have been debating whether the market drop has been in reaction to the twin troubles of the Fed's easing and sovereign debt, or if it's been a natural pullback after a sharp rally. Stocks are coming off a 17 percent surge sparked by a late-summer Bernanke speech that the market widely took to mean that another round of easing was looming.

"Quite frankly, people have gotten bored hearing about QE2. They've gotten bored with the Fed pushing QE2, they've gotten bored with the criticism," says Quincy Krosby, strategist with Prudential Financial in Newark, N.J. "Typically the market can only sustain interest in something for so long before it has to move on to another subject."

Move on it has, and perhaps has left the Fed's efforts behind.

In addition to European debt, investors also have to contend with tightening in China, long seen as the growth engine for the world's economy but now grappling with inflation fears, as well as disappointing earnings from tech bellwether Cisco , which lowered its outlook and raised concerns over whether the pivotal sector would be a drag on US growth.

"It's difficult to tease out how much volatility is coming from the Ireland story and how much is coming from QE2," says Brian Nick, investment strategist at Barclays Wealth in New York. "What's happening in the US Treasury market and equity market is a little bit of jittery uncertainty about how long this is going to last."

Prevailing sentiment is that unless there is another leg lower in one of the major concern areas—if an EU rescue plan for its troubled nations doesn't pan out, or if the nascent recovery in the US slows down, to name two—the current drop is likely just a normal market cycle.

"Longer-term we are bullish. Shorter-term we worry about the unintended consequences of QE such as the decline in the dollar, which hurts consumer spending via higher commodity prices and potentially fuels asset bubbles in the emerging markets," says Michelle Gibley, senior market strategist at Charles Schwab in San Francisco.

"We felt like a correction was possible given the froth that had been built up," she adds. "Corrections would be times to increase investments for those who need to move back to longer-term asset allocations."

But that doesn't mean there isn't more room to fall.

The drop in the markets is just a shade of the meteoric rise in September and October, so more tremors in the euro zone or form China could continue to rattle US markets.

"This is just the ebb and flow of a sideways market," says Gary Flam, portfolio manager at Bel Air Investment Advisory in Los Angeles. "Nobody seems to be giving QE2 any credit for working. It will be interesting to see if it actually does work, because nobody seems to be giving them any credit for the attempt."

Investors for sure can be a fickle group, and for now it seems that the Fed's efforts will be overshadowed by Europe—until the market decides to turn elsewhere.

"Obviously there are concerns, but those concerns have been there before. They have played cameo roles in the market since the beginning of the rally," Krosby says. "It depends what the market wants to focus on. It doesn't matter until the day it matters."