The consensus view that the Fed is going to stop at 'Operation Twist' may be in for a surprise. It may end up doing much, much more. And this may be one of the reasons why the stock market is starting to rally (a classic 50%+ retracement, which always occur after the first 20% down-leg in a cyclical bear market would imply a test of 1,250 on the S&P 500 at the very least). Hedge funds do not want to be short ahead of next week's FOMC meeting, and who can blame them?The above from Rosenberg at Gluskin Sheff, from "Breakfast with Dave", via ZeroHedge.
In other words, if Bernanke wants to juice the stock market, then he must do something to surprise the market. 'Operation Twist' is already baked in, which means he has to do that and a lot more to generate the positive surprise he clearly desires (this is exactly what he did on August 9th with the mid-2013 on- hold commitment). It seems that Bernanke, if he wants the market to rally, is going to have to come out with a surprise next Wednesday. If he doesn't, then expect a big selloff.
What he is likely to do is another story, but here are some options:
- Expand the balance sheet further and simply buy more bonds (at the longer end of the curve).
- Eliminate the interest paid to commercial banks on excess reserves (to try to spur lending).
- Announce an explicit ceiling on the 10-year note yield (say 1.5%), which the Fed has done in the distant past. Based on Bernanke's prior rhetoric, this would seem to be a preferred strategy (though the Fed relinquishes control of the balance sheet).
- Buy foreign securities (bail out Europe and weaken the U.S. dollar — talk about killing two birds with one policy stone).
- Announce an explicit higher inflation target or perhaps a lower unemployment rate target (i.e. reinforce the DUAL mandate).
- As Mr. Bernanke stated for the record in November 2002, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. It could offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector.
Note that this is all for a trade. As we saw back on August 9th, we had a huge rally but the market is no higher today than it was then. All we have seen since is a huge amount of volatility.
Mish Analysis of 6 Alternatives
- Buy the long end of the curve: What would it do? 10-Year yields are near all-time below 2%. Would another .5% lower to 1.5% accomplish anything? About the only thing I can think it might do is increase the Fed's exit problem down the road.
- Eliminate Interest on Excess Reserves: I think the Fed should eliminate interest on reserves because printing money then handing interest straight over to banks on that money is outrageous. However, banks are capital impaired. Paying interest on excess reserves is one way of slowly recapitalizing banks over time. It would be a huge policy error for the Fed (from their point of view, not mine), to eliminate interest on excess reserves.
- Announce an explicit ceiling on the 10-year note yield (say 1.5%): Rosenberg calls this the preferred scenario. It has three problems: It will not accomplish much, if anything, for the real economy. It would increase the exit problem of the Fed down the road. And worst of all it would increase the exit problem by an unknown amount. Defending an interest rate target, as Switzerland just did, means buying unlimited quantities of treasuries from any sellers.
- Buy foreign securities: This one is interesting, and little discussed. Moreover, the market is clearly focused on problems in Europe. Were the Fed to announce backstopping debt of Italy, it could easily start a huge market reaction (if a market reaction is the goal). However, there are obvious political problems of this policy and if the ECB will not do buy sovereign debt, why should the Fed? Note that once the EFSF is in place the ECB stops buying debt.
- Announce an explicit higher inflation target or perhaps a lower unemployment rate target: The goal of driving rates lower while announcing a higher interest rate target sure seems counterproductive, especially at the long-end of the yield curve. Should the Fed announce a lower unemployment target, members of Congress would pressure the Fed until that goal was reached. The Fed most assuredly will not want that pressure.
- Fixed-term loans to banks at low or zero interest: Banks will not lend for 10 years or even 2 years (remember they are capital impaired and have few good credit risks willing to borrow) if the Fed will only backstop the loan for 90 or 180 days. I am not sure the Fed would try this anyway, but if they did I fail to see how it would spur much lending. It does nothing to solve capital impairment.
I see huge potential problems for all 6 of Rosenberg's alternative.
The most bang-for-the-buck (if the goal was to goose the markets), would come from bailing out Europe. Moreover, I suspect Treasury Secretary Geithner might even be pushing Bernanke in that direction with his TALF for Europe ideas.
However, bailing out Europe would be one of the more politically risky choices.
Would that stop Bernanke? Probably, at least for now, but perhaps not down the road when things become unglued in Europe.
Operation Twist Likely
My assessment of the situation is that Operation Twist (selling the short end of the curve and buying the long end to keep from expanding the Fed's balance sheet) will not do any good.
Yet, the Fed will not do much more than that, other than a little extra yapping about what they might do later. When it comes to "later" any of the six items above are fruitful grounds for hope, even though such hope is misplaced as noted by the discussion of problems above.
Gaming the Reaction
The market focus is clearly on Europe. Should good news come out tomorrow say 30 minutes after Bernanke makes his announcement, whatever Bernanke says may be meaningless, even in the short-term.
With that in mind, we just might see an announcement tomorrow afternoon by the EU and IMF that Greece was approved for the next tranche of loans
Thus, meaningless statements from Europe may easily (and temporarily) override meaningless statements from the Fed.
Mike "Mish" Shedlock
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