Stocks Slide on Fears of Cuts to Fedâ€™s Bond-Buying Program

Richard Drew/Associated Press

Ben Bernanke of the Fed spoke about improvements in the economy.

Ben S. Bernanke's confidence in the United States economy did not kill the worm of doubt that has been gnawing at markets.

Investors sold off both stocks and bonds Wednesday afternoon after Mr. Bernanke, the chairman of the Federal Reserve, spoke about improvements in the economy that could allow the central bank to step back from its unusual monetary stimulus of the last few years.

Markets have sold off before and then quickly recovered as they digested Mr. Bernanke's words. Still, the steep market declines on Wednesday underscored the fears circulating through trading desks. One concern is that the economy is not strong enough to do without the Fed's support. Another is that the Fed's decision to ease off the gas could, in itself, cause enough turmoil in the markets that economic growth could be threatened.

"There is a tremendous amount of doubt whether without Mr. Bernanke's help, the economy can keep chugging along," said Thomas di Galoma, one of the heads of bond trading at ED&F Man Capital Markets.

The breadth of the anxiety was evident across bond markets on Wednesday. Investors did not just sell the longer-dated government bonds that the Fed has been buying; they also sold shorter maturities, pointing to predictions that interest rates are likely to rise across the board. The interest rate on the benchmark 10-year Treasury note, which rises as the price declines when investors sell the bonds, climbed to 2.36 percent from 2.19 percent on Tuesday, the sharpest increase this month.

If rates continue to rise, it could crimp lending and eventually hurt the broader economy and stock markets. The Standard & Poor's 500-stock index ended the day down 1.39 percent, or 22.88 points, to 1,628.93 — its worst performance this month. The Dow Jones industrial average fell 206.04 points, or 1.35 percent, to 15,112.19, while the Nasdaq fell 38.98 points, or 1.12 percent, to 3,443.20.

Many strategists said the investors who sent the markets down on Wednesday were panicking and overlooking the nuances of Mr. Bernanke's words. Mr. Bernanke emphasized repeatedly that the Fed was not likely to pull back on the stimulus until it was clear the economy could handle it and could step right back in if there were signs of faltering.

"Nobody is listening," said Gennadiy Goldberg, a rates strategist at TD Securities. "As soon as you give the market anything to chew on, they are going to tear the limb off."

Like many economists, Mr. Bernanke said that it would ultimately be healthy for interest rates to rise from the unnaturally low levels of the last few years.

"If interest rates go up for the right reasons — that is, both optimism about the economy and an accurate assessment of monetary policy — that's a good thing; that's not a bad thing," he said.

What the Fed is hoping to see is gradually rising interest rates alongside a continuing rally in the stock markets.

But Mr. Bernanke acknowledged that he had been caught off guard by the extent of the market's reaction to indications that the Fed may consider slowing down its asset purchases.

"We were a little puzzled by that," he said of the sharp jump in interest rates.

It is the Fed's apparent difficulty in predicting and managing the markets' reaction that represents one of the most disconcerting threats to the economic recovery. Investors could decide that Mr. Bernanke is losing his ability to influence interest rates and continue to sell bonds despite the Fed's efforts to calm the markets. A sudden surge in selling would most likely ripple violently through global markets.

"If bond traders succeed (like bond vigilantes from another era), what does that mean for the economy?" Jonathan Lewis, the chief investment officer at Samson Capital Advisors, wrote in a note to clients.

Most investors consider a disorderly market plunge to be a distant possibility, but there are more widespread concerns about the economy's ability to continue growing without the Fed's help.

The Fed has played a particularly instrumental role in supporting the recovery of the housing market by buying mortgage-backed bonds. These purchases have pushed down mortgage rates and encouraged home buying, which has lifted home prices.

Since Mr. Bernanke first indicated in May that he might step back from the bond purchases, investors have sold mortgage bonds and pushed mortgage rates up. The Mortgage Bankers Association said on Wednesday that the number of new mortgage applications fell 3.3 percent from the previous week.

Steven Ricchiuto, the chief economist at Mizuho Securities, said the housing market and the broader market were more sensitive to rising interest rates than many investors have assumed.

"I don't think this economy is resistant to interest rates," he said.

It appears that the Fed is not ignoring the possible threats to the housing market. Mr. Bernanke said that when the Fed did begin slowing down its bond purchases, it would begin with government bonds, while maintaining the current level of support for mortgage-backed bonds.

Even with Wednesday's market declines, the leading American stock indexes are still up more than 10 percent for the year. The question is whether the confidence that has driven markets up will be sustainable as the date of the Fed's exit draws nearer.

"Investors have been willing to invest because they knew they had the safety net of the Fed," said Larry Peruzzi, a trader at Cabrera Capital Markets. "Now investors are going to have to think harder about taking risks."

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