Following some earlier caveats about an “unusually uncertain” economic outlook, the US Fed last week decided to bite the bullet and buy US Treasury debt from the proceeds of its maturing mortgage assets. In effect, the Fed ended the contraction of its balance sheet – which is simply another way of saying it changed its bias towards tightening (or, more accurately, “normalizing”) monetary policy from its current highly accommodative condition.

In the usual boilerplate accompanying its announcement, the Fed emphasized its concern over the US economy, saying that the “pace of economic recovery is likely to be more modest in the near term than had been anticipated.” It added that high unemployment (currently north of 9%), an erosion of real estate values, and a slowdown in bank lending have held back consumer spending.

While not mentioning the word outright, the threat of “deflation” has certainly been a topic in speeches by Fed governors of late, and it cast a shadow over last week’s decision. Inflation pressures, says the Fed, are trending lower, and are “likely to be subdued for some time.”

So far, so good. And stock markets actually perked up a bit on Tuesday before investors had fully digested the implications of the Fed’s move. But once the market came around to understand that the Fed’s decision is just one small step away from another bout of quantitative easing (“QE2,” as it has been dubbed) – that is, from simply stopping the contraction of its balance sheet to actively increasing it again with a massive securities purchasing program. After all, it has no other choice, argue proponents of the move, because interest rates are already at zero. De facto money printing in a big, big way, they argue, is all that’s left should the economy start sliding into recession again.

Well, we’re not there yet, so all those fears and anxieties may be a little premature. But the signs and portents from other quarters didn’t give investors many reasons for optimism either.

The June US trade report showed that the trade deficit widened by an unexpectedly large amount in the month. The deficit rose 19% from the previous month, as exports sagged 1.3% and imports jumped 3%, raising fears that global growth is losing momentum. The trade numbers got economists recalibrating their GDP growth models, and have generally revised estimates of US GDP growth for the second quarter down to around an annual 1% to 1.25% from earlier projections around 2.4%.

In a related sidebar, Canada’s merchandise trade deficit registered at $1.1 billion, the worst reading in 10 months. Canada’s trade deficit with both the US and the European Union, as exports dwindled across the board. But domestic consumer demand remains strong in Canada, and will likely offset any hit to second-quarter GDP growth from the deteriorating trade picture. Still, a stalling trade picture does not augur well for global growth in the second half.

Conversely, China’s trade surplus increased in July to its widest level in 18 months, leading to predictable calls from Washington for China to loosen its currency peg and let the yuan appreciate even more than it has. Weakening Chinese imports are seen as a sign of slackening domestic demand as the effect of government stimulus wears off and tighter lending rules cool the red-hot real estate market.

Across the Atlantic, the Bank of England issued another gloomy forecast on the prospects for growth. And although inflation hit 3.2% in June, central bankers continued to fret over the potential for falling price levels, leading to speculation that the BoE, too, might be considering another round of quantitative easing.

Investors’ nerves were further frayed by concerns over the health of the Irish banking sector, where two wholly or partially government-owned banks needed some emergency propping up. This comes less than a month after European bank stress tests supposedly calmed markets. Meanwhile, the European Central Bank got busy buying short-term Irish government bonds in an effort to calm market volatility.

And second-quarter eurozone GDP growth was the strongest in four years, at 1% quarter-over-quarter, for an annual rate of 1.7%. Strong industrial growth pushed Germany, Europe’s powerhouse economy, to 2.2% growth from the previous the quarter, and propped up overall eurozone growth, overcoming recession in Greece and only marginal growth most everywhere else in the currency union. With flagging global demand, Germany’s export-dependent economy is unlikely to sustain its higher growth rate.

Against this backdrop, then, it’s no wonder that stock markets got a case of the jitters last week. Bonds soared as yields scratched rock bottom. Thin trading and low volumes magnified the change in investor sentiment and sent the major global indexes reeling as investors lost their appetite for risk.

In North America, the S&P/TSX Composite Index recorded a 2.3% loss on the week, as base metals, gold, and crude oil slid in sympathy with stocks. The Dow Jones Industrial Average retreated 3.3% week-over-week, while the S&P 500 Composite Index dropped 3.8%. All three slipped into the red for the year to date.

For the coming weeks, expect more of the same – wide sentiment-driven market swings and a whole lot more “unusual uncertainty.”

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