Bernanke Fed Will Probably Twist This Week, But Don't Be So Sure of It? ~ MAKE MONEY BLOG$

MAKE MONEY BLOG$~The end of Operation Twist is near, and market expectations are high and rising that Fed Chairman Ben Bernankeand the FOMC will extend the program beyond June, delivering further, yet limited, monetary easing.

It’s not all cut and dry, though, as Bernanke has the difficult task of managing market expectations while keeping enough of the Fed’s powder dry in case of emergency. Ultimately, downside risks have risen (particularly due to Greek and Eurozone concerns) and the U.S. economy has slowed, but not as much as before QE2 was announced, making this a close call.

It has become cliché to paraphrase Shakespeare’s Hamlet when talking about Bernanke’s future decisions. This week, the cliche takes the following form: to Twist or not to Twist, that is the question. Another related, but different, question to ask would be if it’s time for the Fed to retake its preemptive “risk management” approach, championed by Alan Greenspan.

Economic conditions have deteriorated in the U.S., albeit marginally. Economic growth has slowed to the point where Barclays now expects Q2 GDP to grow only 1.8%. At the same time, labor markets have worsened, after a strong start to the year. In May, the economy added only 69,000 jobs, according to the Bureau of Labor Statistics, while the unemployment rate ticked up to 8.2%. Retail sales have weakened and business spending has slowed as a consequence of increased uncertainty, noted Barclays’ analysts.

With a slowing U.S. economy in the background, the two major issues clouding the forecast take on added relevance. On the one hand, the European sovereign debt crisis has once again flared up, with the risk of a Greek Eurozone exit, along with contagion and solvency concerns in Spain, rattling global financial markets. On the other, the fiscal cliff, which promises to deliver $650 billion of fiscal tightening in 2013, along with the debt ceiling debate, will keep markets unsettled and volatile going forward.

So, Bernanke & Co. must weigh the risks and determine what to do. Market expectations for some sort of action, particularly the extension of Operation Twist, are on the rise. JPMorgan Chase’s chief economist for the private bank, Anthony Chan, said he expects the FOMC to extend the Twist on Wednesday, and possibly move toward buying more residential mortgage-backed securities (RMBS), and fewer Treasuries, in order to limit their impact on the Treasury market, while Goldman Sachs’ Jan Hatzius said he expects action from the Fed this meeting.

According to Barclays, the Fed will extend the Twist. Operation Twist was set into action last September as a $400 billion program aimed at lowering longer-term rates while keeping the Fed’s balance sheet from increasing. Analysts suggest the Fed will continue to sell Treasuries with remaining maturities of three to five years, buying longer-term notes with the proceeds; the Fed has about $170 million in Treasuries with remaining maturities of three years of less, which, at the current transaction rate of $45 billion per month means the Twist could be extended for three to four months.

The benefit of extending the Twist, they argue, is that it is much more subtle than outright quantitative easing (asset purchases), while still signaling to markets that the Fed remains ready to provide support. Given that the deterioration in financial conditions since May has been more modest than before QE2, and given the coming elections, firm core inflation, and the stability of inflation expectations, the Twist could be the way to go.

Nomura’s analysts disagree, though. They see the Fed sitting tight, keeping policy unchanged and expressing their concerns through the FOMC statement and lowered projections. According to Nomura, the effect of an asset purchase program like Operation Twist is related to how big a program is announced. A modest extension of the Twist will have a marginal impact, making it unlikely and self-defeating.

Rather, Nomura’s analysts expect Bernanke to keep his powder dry. They expect the FOMC to lower its GDP projections (to 2.15%), inflation expectations (down by about 0.2 percentage points from the current 1.9% to 2% range), while keeping Q4 2012 unemployment expectations at around 8%. By guiding market expectations rather than taking further action, the Fed can give itself room to pursue more aggressive policy if the situation deteriorates.

If the central bank were to announce further easing, the impact on currencies and commodities would likely be significant. The U.S. dollar, for example, would probably drop in value, while gold should surge. Banks will remain under pressure as the Treasury yield is flattened further (big institutions like JPMorgan Chase, Citigroup, Bank of America, and Wells Fargo would be affected), but they would also see greater liquidity in the system. Bond yields should fall further, particularly in the longer end of the curve.

Market expectations are clear: investors, analysts, and economists expect more Fed easing in the form of an extension of Operation Twist. Bernanke has shown that he is a master at managing market expectations, keeping his powder dry long enough to effectively apply policy. If the downside risks are high enough, he could move into “risk management” mode and act preemptively, but don’t consider it a guarantee of further easing on Wednesday.

Source: Forbes.com

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