No Q.E. As Expected. 'Twist' Extended

Tuesday we stated that the Fed would not launch QE 3 yesterday:

For the Fed there is no impetus for launching a QE program at the current time — the market has priced in the bulk of whatever effect it may have had. Furthermore, as stated by Bernanke himself, the diminishing returns of each program are a concern and he will only want to launch further accommodative action only if absolutely necessary. That is not the case at this moment.
 
It is likely that the markets will be very disappointed tomorrow as Bernanke restates his position that he is aware of the weakness in employment, economy and Europe. He will also refocus attention on the current Administration stating that it is the job of Congress to act to create economic growth as the Fed's policy tools are not long term solutions. He will also reiterate his concern over the diminishing return of stimulative programs. However, he will leave the door open further stimulative action if necessary.
 
This outlook was exactly what we saw yesterday in the official press release by the Fed:

Information received since the Federal Open Market Committee met in April suggests that the economy has been expanding moderately this year. However, growth in employment has slowed in recent months, and the unemployment rate remains elevated...Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee anticipates that inflation over the medium term will run at or below the rate that it judges most consistent with its dual mandate.
 
Interestingly the Fed did opt to extend its Maturity Extension Program (MEP), or better known as "Operation Twist", through the end of the year. The extension of the original program will cover about $267 billion in purchases as the Fed will sell bonds with a remaining maturity of "3 years or less" and purchase bonds with "6 to 30-year maturities". This is NOT a balance sheet expansion program, as the previous Q.E. programs were, which injected liquidity directly into the financial markets.
 
This was disappointing to the financial markets which have become addicted to the Fed's "cocaine" which is why the market's initial reaction to the statement was a sharp selloff. The markets have been advancing strongly during recent weeks in anticipation of further liquidity. Unfortunately, the relatively small size of the program will have little effect other than to continue to suppress interest rates within its current lower bound.

However, it is the level of interest rates which remains the real worry for the Fed. With the economy already weak and "growing moderately," which is a better way of saying "sub-par or lower than expected growth", any increase in interest rates at this point will kill any nascent economic growth that may exist. The Fed has been stumped by the inability of the economy to gain traction with interest rates at historic lows as the transmission system has stopped. By all economic theories this should not be the case — yet it is. The chart shows this problem as excess reserves remains bottled up while velocity has plunged.



In this vein that the Fed stated: "To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipate that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014."
 
The long term outlook for continued low interest rates reflects the concerns over "deflationary pressures" and the adverse effects that those pressures have on the economy. "Deflation, as an economic pressure, is very dangerous and once entrenched is difficult to break. For the Fed the fear of inflation is far less worrisome than the concerns of a severe deflationary bout in the economy."
 
For Bernanke another round of QE is inevitable, however, we can now push our original window of August-September out until after the election most likely. This was a good political move for Bernanke not to be seen as influencing the upcoming election. However, the markets and the economy may not "buy" him that much time. The size of the program is simply too small to offset the effects of the Eurozone drag on the U.S. economy which is the Fed left the door open for further actions by stating "The Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability."

For investors it is important to consider the risk to investment portfolios in the current environment. With the crisis in Europe brewing, an upcoming election, weakening economics and a potential debt ceiling debate just around the corner it is very likely that we could see a slide in the markets into the August-September period. The current June rally has taken the markets from oversold at the end of May to very overbought currently. Each of the past two summers has played out very similarly, and in both cases, the midsummer rally led to further declines. Will this summer play out exactly the same? It is all a guess. However, from an investment standpoint, the current levels of downside risks grossly outweighs the odds of success. We continue, as we have since April, to recommend holding more cash and fixed income at the current time and wait for a better buying opportunity in the future.