We’ve recently entered bizarro-investing-world, where good news is bad for the markets and bad news makes them perform better. This has happened many times before, as it’s part of the linkage between the Fed’s interest rate policy and the financial markets. But it’s often confusing for investors, especially newer ones who haven’t been through it before, so here’s a primer to help you sort it all out.

How We Got Here

When the financial crisis struck in 2008, the economy and financial markets were both at serious risk of melting down. The government and Federal Reserve both poured liquidity into the system in an effort to avoid the destructive deflationary spiral that seemed to be beginning: falling asset values (home prices, financial asset prices) cause spending to contract, which causes business earnings to contract, which causes layoffs, which causes further contraction in spending, and round and round it goes. Because of the speed and magnitude of these declines (due in large part to debt and leverage magnifying the impact), things got very bad very quickly.

That’s a broad-brush summary, but whether you think those moves were appropriate or not, they were taken and the course was set for the next four years or so. During that time, we’ve seen other central banks follow the lead of the US Federal Reserve in implementing “Quantitative Easing” (QE) programs. In a nutshell, these central banks have been buying up (mostly) government debt of various types. This has had the effects of putting more money into circulation (the “printing money” accusation) and lowering the yield on government debt by creating a huge source of demand for it.

When bond yields move one direction, bond prices move the opposite direction. So by propping up bond prices through its purchases, central banks were effectively pushing bond yields lower. While QE has focused on government bonds, those government bonds serve as the baseline for pricing all other types of debt. By pushing government bond yields down, the central banks have effectively shifted the whole income-producing spectrum lower: everything from bank savings accounts to riskier corporate debt has been impacted and yields have shifted lower across the board.

There’s also a connection between stocks and bonds in that they “compete” for investor attention, and when bond yields drop so low, it makes stocks relatively more attractive. By pushing the yields on savings accounts and bonds of all types lower, stocks have been made relatively more attractive. Until just recently, the dividend yield on many blue-chip stocks was actually higher than the yield on the same company’s bonds. This dynamic is partly why many people feel the stock market rally since 2009 has been artificially inflated by the Fed’s (and other central banks’) actions.

Now, it’s important to remember that as all these events were unfolding, most conservatives decried each move as a bad thing. Initial Fed intervention, bad. Initial government stimulus bill, bad. Partial takeover of General Motors, bad. QE 1,2,3,4, bad x 4! I happen to agree with those assessments for the most part. While some of the actions may have been necessary or at least defensible, it’s generally a bad thing (in my opinion) for the government and Fed to be more actively involved in the markets and economy.

The Fed Has More Change in Store

The Fed has begun talking about unwinding its QE programs, and this talk has set the markets on edge. In fact, the stock market was plowing full steam ahead until the very moment Fed Chief Ben Bernanke let it slip during a May 22 Q&A that the Fed could start to tighten monetary policy “in the next few meetings.”

Now let’s back up. If it has basically been “bad” that the Fed has been implementing these unprecedented policies in an effort to prop up the economy, and now they feel like the economy is getting strong enough that they can start thinking about backing away from those unusual policies, is that a bad thing or a good thing? Overall, getting the Fed out of the financial markets and putting an end to the distortion they have been creating is a very positive thing.

The (multi) million dollar question is how smoothly the Fed will be able to exit these policies. In other words, are the financial markets going to capsize once it’s clear the Fed is scaling back?

That fear is what has put the recent wobble into stock prices. The reality is nobody knows how it will play out, as the Fed has never done anything like this before. But here are a couple of thoughts as to why I would be surprised if this really was the beginning of anything more than a routine correction.

First, the stock market has been on fire for almost six months straight. When the market goes almost straight up 25% without a breather, it’s natural for a pause or pullback to happen. When it does, a rational explanation is generated. But something would have stalled stocks’ momentum before long even if Bernanke hadn’t said what he did. The market was due to at least pause, if not correct a bit.

Second, it’s important to note that the Fed is way out at the extreme edge on the monetary policy spectrum. The normal range involves moving the Fed Funds rate up and down. The multiple QE initiatives only came about because the Fed had already pushed its normal level all the way down. So far, none of the QE stuff has officially been scaled back, but even after that’s all wrapped up, monetary policy would still be extremely loose by pre-2009 standards. Bull markets typically don’t die until the Fed tightens monetary policy a bit. Again, no one knows how the reaction this time may differ, but there’s a lot of room between talking about scaling back QE (where we’re at today) and actually reaching anything resembling non-loose monetary conditions.

So as you see the markets moving up and down in the weeks and months ahead, keep in mind that the explanations that accompany these moves are basically going to be the opposite of what you’d otherwise consider to be good or bad. Economic growth is perking up? Expect stocks to fall, as it makes it more likely the Fed will end QE sooner. Unemployment numbers suddenly get worse? Expect stocks to rise, as real-life weakness makes it more likely the Fed will continue to prop up the markets via QE.

We’ve reached the point in time where good is bad, and up is down. And we could be here for a while.

Mark Biller

By Mark Biller

Mark Biller is Sound Mind Investing’s Executive Editor. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark is also the Senior Portfolio Manager of the SMI Funds.

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