The Fed calls the tune for markets Wednesday, and Wall Street is hearing Chubby Checker.
Markets are expecting the Fed to unveil a modern day "Operation Twist," similar to a Federal Reserve program in the early 1960s which was named for the famous dance, the topic of Checker's songs. Fed watchers speculate on various degrees of easing, but they basically agree the Fed is about to unveil a program to buy longer dated Treasury securities in a bid to hold down interest rates.
"I don't think we get a whole lot of shouting. Just a little twisting," said Morgan Stanley's Jim Caron, who heads interest rate strategy.
The Fed's meeting got underway Tuesday, and it is expected to issue a statement at 2:15 p.m. Wednesday. The Fed also meets as the political rhetoric in Washington heats up around President Obama's proposal this week for tax hikes.
The Republican Congressional leadership Tuesday, in a rare move, sent a letter to Fed Chairman Ben Bernanke telling him further Fed action could harm the economy and that it could erode the dollar.
The letter was signed by House Speaker John Boehner (R-Ohio), Majority Leader Eric Cantor (R-Va.) and Sen. Minority leader Mitch McConnel; (R-Ky.) and Jon Kyl (R-Ariz.). They also wrote that he should resist further intervention and there's no evidence further monetary stimulus will create jobs or help the economy.
Analysts have been expecting Congress, at some point, to take aim at the Fed. Some even expect the Fed to hold back on other stimulus steps it might have taken to avoid the line of fire.
Richard Bernstein, CEO of Richard Bernstein Capital Markets said in a recent interview that after the Fed does 'twist,' it is unlikely to do anything else major. "I think the politics are such that the Fed is basically hog tied. 'Operation Twist' is not new stimulus. It's carrying on. What the Fed is trying to do is flatten the curve so they bring longer term rates down," he said.
Traders and analysts have debated just how much and in what way the Fed will take aim at the longer duration Treasurys. Some believe the Fed will retool an existing program, which invests roughly $20 billion a month runoff from its mortgage portfolio. The Fed could start using the runoff to buy just the longer end of the curve, not the whole curve.
Others, like Caron, disagree and expect the Fed to restructure its portfolio by actually selling shorter duration securities and buying the longer duration. "We think they sell 2 to 2.5 year paper and that could reap up to $300 billion, and they can take that cash and redeploy it into other parts of the curve," Caron said. "..What the consensus is saying is the majority of the purchases stay in the 8- to 10-year pocket." He said the Fed would also purchase some 25- to 30-year bonds.
"A lot of this has been priced in," said David Ader, chief Treasury strategist at CRT Capital. "However, we don't know the magnitude and in our estimate the Fed could buy as much as $650 billion of longer duration. They would have to sell (Treasurys) to get there." Ader said the street consensus is that the Fed buys $400 to $450 billion.
While conventional thinking is that the program would hold or even push rates lower at the longer end of the Treasury curve, Caron said the program may have the opposite affect if it is successful. "If they go into the long end, they crowd investors into other asset classes, and that's how the Fed creates an easing of financial conditions," he said.
"The issue is, if we think about this in a much more macro sense. We have to recognize the economy is in a deleveraging phase... the borrowers are deleveraging so they have less incentive to borrow in this environment," said Caron.
Caron said he expects 'twist' to be only successful at the margin, especially without accompanying fiscal stimulus. Caron said the smaller 'twist' program will be less effective than QE2.
Under the QE2 program, the Fed purchased $600 billion in Treasury securities across the curve, adding them to its already bloated balance sheet. That program was widely credited with driving investors into riskier assets, like stocks and commodities. It also pressured the dollar. Fed watchers have become less certain that the Fed would consider doing a third quantitative easing program, but the 'twist' program is seen as likely.
"The market believes they're going to do the 'twist.' The market implemented half the twist for them. The yield on the 10-year came way down. This is Bernanke's favorite way. He steps aside and let's the market do it for him," said Art Cashin, head of floor operations at UBS. The 10-year has been trading at 1940s levels, and was at 1.947 percent Tuesday.
"I think the market gets destroyed if they don't do this. The market is so expecting this," said Caron.
Some strategists also expect the Fed to cut the current 0.25 percent interest rate it pays banks to hold reserves by 0.10 to 0.15 percent.
The Dow Monday finished 7 points higher at 11,408, and the S&P 500 was off 2 points at 1202. The market was higher most of the day, as traders looked forward to the Fed announcement Wednesday and also on the prospect that the IMF, European Union and European Central Bank would come to an agreement to help Greece. However, the troika late Tuesday made it clear it would not make a decision on Greece until October, and the market took the comment negatively even though it was not a new development.
Besides the Fed meeting, investors are watching existing home sales data at 10 a.m. President Obama also speaks at 10 a.m. to the U.N. General Assembly.
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