Stocks gyrate as U.S. economy nears crucial test

(MoneyWatch) "Tapering." It is the word on all investors' lips these days, as financial markets around the world gird for the day the Federal Reserve halts its regimen of monthly adrenaline shots for the U.S. economy.

Hoping to ease the pain, the central bank has emphasized that when that time comes, it will merely start to scale back its massive bond purchases rather than summarily pull the plug.

Nice try. The Dow Jones industrial average, which reached an all-time high on May 28, fell more than 250 points earlier this week before rebounding strongly on Thursday. The broader Standard & Poor's 500 and Nasdaq composite indexes have also retreated, while gold prices, another key gauge of investor sentiment, continued their weak run this year. Bond yields are rising, too -- if that continues, borrowing costs could climb enough to hinder the economic recovery. 

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Ever since the Fed started pumping money into the economy in 2008 in a move to pep up stocks, curb longer term interest rates and generally boost economic activity, investors have been preparing for the day when the tap would be turned off. But speculation over exactly when and how that would occur intensified on May 22, when Fed Chairman Ben Bernanke told a congressional panel that withdrawing support prematurely would reduce growth.

In follow-up responses to questions from lawmakers, however, Bernanke said the Fed might begin withdrawing support over the next few months if the job market continued to heal. Later that day, the release of minutes from the Fed's most recent policy meeting further clouded the issue by suggesting that a number of bank members favored reducing the volume of bond purchases as early as June.

As usual in such moments of uncertainty, investors promptly turned cautious.

"The recent decline in bullish sentiment mostly reflects investors' confusion and uncertainty about the monetary policies of the major central banks," said Ed Yardeni, president and chief investment strategist for institutional investor advisory Yardeni Research, in a research note. "The fear is that the monetary authorities will start cutting back on the high-octane liquidity they have been adding to the financial markets' punch bowl."

Are such fears founded? Yes and no. Although economic forecasters differ on exactly when they think the Fed will start tapering bond purchases, all signs points to it happening soon. Most Fed watchers think the process will start as early as September, and likely no later than the first quarter of 2014.

Still, it won't happen overnight. The bank is almost certain to take incremental steps, paring its $85 billion in monthly bond purchases in stages. It also has vowed to keep monetary policy "highly accommodative," Fed-speak for the easy-money policies that have helped stimulate growth, even well after the economy gathers speed.

"As the Fed tapers, it's not restricting monetary policy -- it's just expanding bond purchases at a slower rate," said Nariman Behravesh, chief economist with IHS Global Insight. The research firm expects the economy to grow around 1.5 percent in the second quarter, down from 2.4 percent in the first three months of the year, before increasing to roughly 3 percent by year-end.

Another factor to consider: The economy, while hardly flying high, is likely in better shape that it appears. That should cushion the impact of a Fed pullback. A recent slowdown in growth is largely the result of the sequester, the federal spending cutbacks that took effect in March, rather than fundamental weakness in the economy.

"Assuming that tapering occurs toward the beginning of next year when the economy is growing around 3 percent, the timing will be right," Behravesh said. "The economy will be able to absorb this tapering." 

He added that the "underlying dynamics for the U.S. economy are very strong," noting the stronger job-creation in recent weeks, rising home prices and easier credit conditions. 

At least some investors appear to think that stocks are oversold. After its sell-off earlier in the week, the Dow gained 181 points, or 1.2 percent, Thursday to close at 15,176.

Economic projections aside, such views require a little perspective. The stock market is a poor proxy for the wider economy where most Americans pay the bills, with about 80 percent of stocks held by the wealthiest 10 percent of the population. Most people's wealth is tied up in their homes, which remain well off their pre-housing crash peak, and live off their wages, which are stagnant. Job growth remains middling at best, with 11.8 million Americans still unemployed.

Perhaps more troubling, it remains unclear exactly what sort of deeper structural changes are under way in the economy as it crawls out from the epic collapse triggered by the financial crisis. Many of the jobs that have been created during the recovery have been in lower-paid industries, such as restaurants and retail. More companies are also shifting full-time jobs to part-time work. For a country where consumers account for some 70 percent of economic activity, such trends may not be compatible with healthy growth.

Bernanke's next opportunity to signal the Fed's intentions will come at a June 19 press conference following two days of meetings by the Federal Open Market Committee, the Fed's monetary policy panel.