No matter what the Fed does, some corner of the financial markets will be unhappy Wednesday afternoon.
In the last several weeks, as Europe`s sovereign crisis flared and US economic news simultaneously worsened, the expectations on Wall Street have gone from no new Fed easing to the Fed potentially launching a new extraordinary, quantitative easing program at the end of its two-day meeting Wednesday.
The consensus appears to lie somewhere in between, with the most odds seemingly on an extension of the Operation Twist program that is currently scheduled to end at month end. Even while some analysts question how much the Fed can ease with near record low rates, they still expect to see some action.
"I think tomorrow`s meeting has a bit more surprise potential than we`ve seen in the past, and I think the market is appropriately cautious ahead of that event," said Ian Lyngen, senior Treasury strategist at CRT Capital. "I think stocks continue to trade on the assumption that the Fed will deliver something. If not QE, then it will be a version of Operation Twist which they see as positive."
Lyngen said the bond market is expecting Twist, not quantitative easing.
Operation Twist is a Fed program that involves the sale of shorter duration Treasurys and the purchase of longer duration securities, in an effort to pressure longer term rates. QE, or quantitative easing, is different and it involves the Fed making asset purchases but adding them to its balance sheet rather than holding the size of the balance sheet steady with asset sales. There are expectations that a new QE could involve mortgage securities, or even that an extended Operation Twist may target them.
"As the data`s gotten worse, the odds go up," said JPMorgan economist Michael Feroli. "Basically my view of the Fed reaction function hasn`t changed that much. It`s just that the data deteriorated."
Stocks soared Tuesday, with the S&P 500 gaining nearly a percent, and the dollar fell, reflecting some expectations for easing. Markets were also buffeted by a variety of headlines from Europe which quoted sources showing some willingness by euro zone officials to renegotiate Greece`s bailout and stories that both suggested and knocked the idea of Europe`s bailout mechanisms buying more sovereign debt.
Treasurys were also reacting in part to the recent sell off in German bunds, resulting in a five-week high yield, as traders see the euro zone successful in buying more time towards a solution.
The bond sell off, along with weaker mortgage prices, was also seen as a move by some investors to take off some bets on Fed easing, in case Operation Twist or QE does not materialize.
"Many market participants are expecting some kind of accommodative move tomorrow from the Fed in the form of an extended twist or `verbally` by saying rates will stay low beyond 2014. Given the markets` run of the last 4 days, profit-taking on the news, good or bad, may be in order," Stifel Nicolaus strategist Elliot Spar said in a note.
He said the S&P 500 reached his target of 1,358 and investors should consider taking profits or hedging with options though the market could surprise to the upside.
BTIG chief global strategist Dan Greenhaus said if the Fed announces just Twist in its 12:30 pm ET statement Wednesday that may not do much for the stock market, but no action would be taken as a negative. A new round of QE would drive stocks higher.
"We knew when they started stepping into these programs, we knew that things were getting esoteric and we knew they had run out of the types of things that people fully understand, and once you get into Operation Twist and the communications strategy, then you enter a realm where the effects are not fully understood," he said.
Greenhaus said he believes the Fed should refrain from continuing Twist because it does not have much impact, saving its firepower if it needs to use a full QE program. "I`d like to see them say the economy is on stable footing. Its being influenced by external factors and we stand ready to provide support if necessary. But to be clear, the economic data points have worsened," he said.
The Fed also releases its revised economic forecast at 2 pm ET and Fed Chairman Ben Bernanke then speaks to the media in his quarterly briefing.
JPMorgan`s Feroli had previously expected no Fed action, but he`s changed his view as the weaker data piled up and he simultaneously pared down his expectations for second quarter GDP, now at 2%.
"We think they extend twist and they push back guidance to 2015," he said. The Fed`s current guidance for extremely low rates is through 2014.
Feroli said the Fed has been caught off guard by the rate at which the economy deteriorated, and its communications have been overtaken as a result.
That could explain the wide range of views. Goldman Sachs economists say their base case is for a third round of QE, with an extension of Operation Twist at the very least.
Pimco says it`s all too close to call, according to strategist Tony Crescenzi. But personally, Crescenzi expects the Fed to hold off.
"I think the Fed will wait until the next meeting, and if necessary depending on more data and the outcome in Europe, deliver outright QE. If you`re going to do something, do something, rather than extend Twist," he said.
Crescenzi said the Fed will likely strengthen the language about easing if needed. "What the Fed wants to do is put a safety net under markets in case the data is weak," he said.
"Europe is driving conditions in financial markets, and the Fed can`t control that...so they might want to be ready to react to it," Crescenzi said. "Why not pull the guns out when the battle really begins?...Financial conditions haven`t changed all that materially. There`s still a question about this slow down and what`s behind it."
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