Published August 14, 2009

Fed does right by bullish market

Markets shoot to highs on Fed's Wednesday decision to leave funds rate at zero to 0.25%

By ANDREW MARKS
NEW YORK CORRESPONDENT

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THE jitters preceding the Wednesday afternoon conclusion of the US central bank's interest rate policy meeting may have surprised some investors. With the health of the US economy still fragile and the strength of recovery a matter of great concern, it seemed highly unlikely that the voting members of the US Federal Reserve's body responsible for setting all-important short-term interest rates would choose this as the time to shift from a near-zero federal funds rate.

But with the recession ending, investors have begun to wonder and fret over when the Fed will raise rates - and what that will mean for the recovery. So while the Fed's decision on Wednesday to leave the funds rate at zero to 0.25 per cent was a yawner on Wall Street, the market was on high alert for any other signals that the Fed might send on its view of the economy and when it might judge the financial system strong enough to allow it to return to normality.

On Wednesday, the Fed offered signals on both - and investors liked very much what it had to say.

'You really couldn't have asked for more,' said Joel Naroff, president of Naroff Economic Advisors. 'The Fed gave the market exactly what it wanted to hear - that the economy is levelling out, but that the stance on interest rates will remain in place until growth is on a sustainable basis.

'And then it made overseas investors very happy with the announcement that it will phase out the purchases of Treasury securities by the end of October.'

The major US stock indices, which had risen early on Wednesday, hesitated only briefly as investors digested the Fed's words, before shooting to closing highs. The Dow Jones Industrials added 120.16 points or 1.3 per cent to 9361.61, and the S&P 500 up 11.46 points or 1.2 per cent to 1005.81. The Nasdaq Composite edged up 28.99 points or 1.5 per cent to 1998.72.

On Thursday, the market kicked off in rally mode due to the Fed's upbeat comments, traders said. But the early gains were more modest than expected and soon turned to losses due to retail sales and jobless claims reports that fell short of expectations.

After opening with a 20-point gain, the Dow slipped into negative territory as investors fretted over 558,000 new unemployment claims and a 0.1 per cent decline in July retail sales - a much worse performance than the 0.7 per cent gain that economists expected.

Economists also expected slightly fewer claims - 545,000. But in the midst of such a big rally, investors appear ready to take profits at even the slightest indication of bad news.

By 10 am, the Dow was off 44 points or 0.47 per cent at 9,317.63. The S&P 500 was down four points or 0.4 per cent to 1,001.73, while the Nasdaq Composite had slipped eight points or 0.41 per cent to 1,990.56.

The key change in the Fed's statement was an alteration in its description of the economy. In the June statement, it said: 'The pace of economic contraction is slowing.' This time around, it said that while 'the economy is likely to remain weak for some time', it believes that 'the economy is levelling out'.

Mr Naroff said: 'That may not seem like a lot, but it is. It tells us the Fed believes the recession is basically over. At the same time, it made clear that the need to be certain of a sustainable recovery means we will not be seeing a rate hike soon. That's nothing but a positive for investors.'

For analysts and stock traders such as Nick Colas, who runs several funds for BNY Convergex Group, the Fed's announcement that it may end the programme to buy up to US$300 billion in long-term government securities by October was just as important. 'Many investors have viewed this quantitative easing policy as the single most destructive practice undertaken by the Fed or Treasury in terms of confidence since the whole crisis began,' he said.

'It is virtually impossible for the Fed to prove that it isn't just buying Treasuries directly from the government, and such a breach of central bank independence is very damaging to long-term global confidence in the US banking system.'

Mr Colas pointed out how upset China has been with the way that the US has been monetising its debt to spend its way out of the recession.

That the Fed is prepared to end this programme means that it is ready to turn over the operation of the financial system back to the markets, said Mr Naroff. 'It means we're ready to get back to normal, and that's a big confidence booster.'