Will The Fed's Operation Twist Disappoint? - John Rothe | Portfolio Manager, Quant, Tech Geek, And Sometime Superhero To My Kids

Will The Fed’s Operation Twist Disappoint?

operation twistToday starts the Federal Reserve Board’s 2 day FOMC meeting. All eyes will be on tomorrow’s statement from the Fed. The FOMC will be discussing “Operation Twist”, its newest endeavor to stimulate the economy. However, the market seems to be a bit worried and unsure about what the details will be – to the point that traders don’t want to be long or short this market

From Morgan Stanley strategist Greg Peters:

“As we head toward this week’s FOMC statement, investors are quite nervous and reluctant to be short, with many of their hedges taken off. Thus, if investors get hit with disappointing news over the next couple of days, we could see a powerfully negative reaction in the markets.”

Merrill Lynch had their take as well:

The equity market doesn’t perceive it to be as effective: Although normally positive, the correlation between rates and stocks typically turns negative in anticipation of Fed easing. Lower rates (pricing in additional demand) and higher equities (portfolio-balance channel) have been a sign of pricing in increased Fed accommodation, historically. As a result, the rates- stocks correlation usually turns negative when the market is focused on the next Fed step… However, this time around the correlation is still at 70%.This can be attributed to one of two factors – 1) The market is pricing in that policy action this time around will not effective in stimulating growth, unlike QE2 was perceived to be. 2) The equity market is not pricing in any further accommodation, which is unlikely given the repeated mentioning of this policy tool by FOMC members, including Chairman Ben Bernanke and the minutes of the Aug FOMC meeting.

Inflation expectations have not risen: Inflation expectations, as reflected by 10y TIPS breakevens have in fact declined over the last few weeks, though we think the market has priced in an increasing probability of additional monetary easing. This is unlike QE2, when breakevens increased nearly 100bp from their lows in August… if OT was perceived as being effective in providing a boost to the economy, arguably inflation expectations would not have declined. This argues that the market does not perceive OT as being as effective.

In fact, I have been talking about if the S&P 500 is stuck in a bearish flag pattern or is on the verge of a powerful upwards breakout. The S&P 500 is moving towards and invisible “brick wall”. A break above the 50 day moving average will certainly been seen as a positive to traders. With the next level of resistance being the 200 day moving average.

john rothe

However, if the Fed disappoints and the markets fail to break through, we will see quite a few shorts enter this market – and a resumption of a bearish flag pattern.

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