Rosenberg Presents The Three Ways Bernanke Disappointed The Market, And Why It Is Dumping

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With everyone chiming in with their take on Operation Twist, here is one of the few actually worthy ones on the matter.

From David Rosenberg

First, the Fed once again downgraded its outlook on the economy, citing "significant downside risks" (the word "significant" was not there on August 9th) and added "strains in global financial markets" as one of the reasons for the more downbeat assessment.

If there hadn't been so many trial balloons being floated in recent weeks over the prospect of an Operation Twist ("OT") style of policy easing, perhaps the stock market would have rallied as it did in rather dramatic fashion six weeks ago. At that time, the Fed did surprise the market by not merely signalling to investors that the central bank would remain accommodative beyond just what may be considered to be an "extended period", but by actually stating that rates would be kept near 0% through mid-2013 at the very least. That was something that both bonds and stocks were not anticipating — a specific date well into the future.

This time around, there was very little that was not anticipated, particularly from a stock market perspective. Considering that Mr. Bernanke made this a two-day meeting instead of the one-day confab which was originally planned (the last time he did that was in December 2008 when QE1 was pledged), there were high hopes that the Fed was going to go further than just embarking on OT yesterday.

But the reason why equities may have sold off hard in the aftermath of the press release could boil down to these three other factors:

  1. By radically flattening the yield curve in this Operation Twist program (where the Fed sells short-dated securities and buys maturities between six and 30 years), net interest margins in the banking sector will likely be negatively affected.
  2. The dramatic decline in the 30-year bond yield is going to aggravate already-massively actuarially underfunded positions in pension funds
  3. The Fed says it is going to extend this Operation Twist program through to June 2012. This is a subtle hint to the markets that barring something really big occurring, there is no QE3 coming — not over the near term, in any event, and certainly not at the next meeting on November 1-2. So a stock market that has continuously been fuelled on hopes doesn't have any in this regard for at least the next month and a half.

    There is now likely to be very little talk about another round of Fed stimulus, and as such, one less crutch for the bulls to lean on. If the Fed, for instance, had said that the OT would have a December 2011 expiry date, the markets would be salivating over what would come next. But June 2012 is a good nine months away (it was deliberately drawn out). It would seem strange at this point, barring a cataclysmic event, to have the Fed embark on a new QE strategy at a time when OT is still in play, not that it can't happen. What is key is that the Fed did find a way to say to the market that this is it for a while, perhaps until we are well into 2012.

As for the fixed-income market, the big news was the size of the OT program ($400 billion versus market expectations of $300 billion), but the bigger news was that the switch was not merely going to be in the 7-to-10 year part of the Treasury curve — in a real 'twist', it will also include the long bond, as mentioned above. What the economic benefit of this will be is really anyone's guess, but it is making long duration bond bulls ecstatic. The yield on the 30- year Treasury bond has fallen all the way down to 3%, but it is the only maturity that has yet to make it all the way down to a new cycle low; there is still nearly 50 basis points to go before the December 18, 2008 interim trough of 2.53% is tested (back then, the recession was largely behind us, not ahead of us). While the "bond" may look overbought right now on a technical basis, there has never been a time when yields bottomed before the recession even began.

Besides, a normal curve from overnight to the long bond is around 200 basis points, so to see an eventual retest or piercing of that 2.53% close of 33 months ago is not out of the question. We should add right here and right now that 30-year German bund yields are now at their all-time low of 2.46% and they don't carry nearly as well as Treasuries. The yield on 30-year JGBs are now at 1.9% and in Switzerland the long bond yield is now 1.2%, added evidence that a further dramatic rally in the long-term Treasury is far from a radical viewpoint.

The mortgage market also got a bit of help today — though likely not much — from the Fed's move to reinvest the principal payments from its maturing agency debt and agency MBS securities into agency MBS (instead of Treasuries as it had been doing).

All in, quite a tepid response to an economic outlook that now has "significant downside risks" when benchmarked against what was priced into the stock market. But there still were three dissenters and the tone of the press statement suggests that the meeting was a lively affair and not short on compromises (the FOMC minutes will be released on October 12th). If there is a surprise, it is the inclusion of the long bond in the program. At the margin, this was a backhanded signal that, sorry, this was not Step One with Step Two coming any time soon as it pertains to further monetary policy intervention in the marketplace. And when you look at the chronology of events — taking rates to effectively 0% in December 2008; embarking on QE1 in March 2009; moving to QE2 in November 2010; and now this Operation Twist resurrection, it is abundantly clear that the Fed has moved from cannons to shotguns to water pistols.

Source: Gluskin Sheff