The recent release of James Bullard’s Fed paper on quantitative easing (QE) may have set the market’s expectations too high today for a significant shift in Fed policy. We believe it is only a matter of time before the Fed announces the second round of quantitative easing (QE2), but that time may not be today or even in the next few months. We have been in this business long enough to know trying to anticipate what is coming in a Fed announcement is difficult at best. Since the Fed will be the main focus of the day, here are a few possible outcomes for today’s 2:15 p.m. ET release, starting with what we believe to be the most probable:
- Commitment to reinvest cash returned via principal and interest payments from the first quantitative easing program (QE1), where the Fed bought mortgage-backed securities. The market’s possible reaction in this scenario is difficult to wrap your arms around. Market participants could be disappointed since this is not announcing a full-blown new round of QE2. Market reaction could be positive with an assumption this is the first step toward a full blown QE2.
- Only make changes to the statement with no specific mention to quantitative easing. Rewording might include phrases such as “the economic outlook is highly or unusually uncertain…the Fed stands ready to take action if necessary”. The odds probably favor a more muted or negative reaction to such a statement. It is possible this scenario sparks a sharp short-term sell-off in stocks, commodities, and precious metals. Eventually, the short-term selloff would be probably be met with buyers as market participants begin to believe the Fed will most likely take additional action sooner rather than later.
- Announce a full blown second round of quantitative easing (QE2). This could spark a very sharp rally in stocks, foreign stocks, oil, copper, silver, gold, and commodity-based currencies. We believe the odds are lower than the market believes that we get this outcome today. As of this morning, the odds are not insignificant, but they are probably closer to 50% than most market participants believe.
- Produce a statement that is basically the same as the previous statement. We may see something in the order of “rates will remain low for an extended period”. This could produce a significant sell off lasting several days.
- Announce a reduction in the interest paid to banks on cash reserves held at the Fed. We believe this is the lowest probability outcome and one that would not be received well by a market looking for something related to quantitative easing.
Obviously, we could see combinations and permutations of the scenarios outlined above. While the Fed’s statement could be met with a volatile reaction (either up or down), Fed statements rarely change the intermediate-to-longer-term trends in the market. As we enter today’s meeting, the markets have a bullish bias from a risk-reward perspective. The bullish bias is not firm, nor is it significant, but it still remains bullish. Consequently, for our time horizon we believe the best way to “play” today’s Fed announcement is to stick to our plan. As we have and will continue to do, if the markets deteriorate to a point where the odds of lower lows become greater than the odds of higher highs, we will adjust accordingly.
There is no need to predict what the Fed is going to say today or guess how the market will react; doing so makes for good conversation, but it is not a sound way to manage money. The best approach is to pay attention with an open mind and continue to take the market’s temperature as events and reactions unfold, which is exactly what we plan to do. The market’s firm reaction to today’s statement may not be known until Wednesday’s close. It takes some time for markets to digest the possible impact on any new Fed policy or possible shift in policy.
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