Everything today is all about the Fed, which at 12:30 pm will release its standard statement. The publication of Fed officials' forecasts and Chairman Bernanke's press conference will follow at 14:00 and 14:15, respectively. Some, like Goldman are convinced the Fed will announce new easing measures, which could take the form of a new LSAP, more Twist as well as a lengthening of short-term rate guidance beyond 2014, potentially going as far as announcing a Flow-based form of QE, while others such as BofA are fairly certain nothing will happen. Then at 2:00 pm the Fed will release its new economic projections, in which it is roundly expected that the Fed will revise its GDP forecasts for 2012 and 2013 lower, and unemployment - higher. Finally at 2:15 pm Bernanke will address Steve Liesman and a few other members of the fawning captured media. By then the market will be either much higher or much lower, although with about 5% of the recent market move driven entirely by pricing in of more QE, the risk is to the downside. In other words the hopium phase is over. It is now make or break for the Fed.
Full recap of the last hopium rally in a rally from BofA:
This afternoon the Fed is due to announce any changes to their monetary policy stance. Below we provide a full preview. Overnight Asian equity markets rallied as markets participants increased their expectations that the Fed would either extend Operation Twist or announce a new QE program. We expect neither from the Fed at today's meeting. That would let markets down leading to a sell off after the meeting in the equity markets. Also helping sentiment was the statement from G20 leaders saying that they pledged to support economic growth and help overcome Europe's debt crisis. We think pledges from global leaders will not solve the problems in Europe. Europe needs real internal leadership to drive the hard choices - further integration on the political, fiscal and banking fronts -nothing, in our view, has changed the situation in Europe after the G20 meeting.
That said, Asian equity markets rallied sharply with the MSCI Asia Pacific Index up 1%. The index has now reached its highest level since May 15. Looking at the individual markets, the best performer was the Japanese Nikkei up 1.1%. The Korean Kospi was a distant second up 0.7% and the Hang Seng rounded out the top three up 0.5%. The Indian Sensex managed to finish 0.2% higher while on the flip side the Shanghai Composite fell 0.3%.
In Europe, equities are trading 0.1% higher in the aggregate. Shares listed in London are outperforming the other major indices up 0.4%. At home, futures are pointing to a flat open later today. That follows yesterday 1.0% rally. The market should remain relatively unchanged up until today's FOMC announcement in the early afternoon.
In bondland, Treasuries are backing up modestly. The 10-year yield is 1bp higher at 1.63%. In Europe, yields on Spain's 10-year have fallen below 7%. The note's yield dropped 13bp to 6.83%. Italy's 10-year borrowing costs are now below 6% at 5.80%.
The dollar is trading flat against a basket of other major currencies. Commodities are slightly lower with WTI crude trading at $84.02 a barrel and gold at $1,612.23.
FOMC: Holding on loosely
Our long-held view has been that the Fed will launch QE3 by early fall, and that remains our view today. We also think it will not start hiking interest rates until mid-2015 at the earliest. Exactly when the Fed will announce such easing actions depends on the outlook and risks. We see about a 1-in-3 chance that it will launch a significant action in June, although by September we see a 75% chance of QE3. At this meeting, we expect Fed officials to sound very dovish, lower their forecasts, and signal that they are on "high alert." Nonetheless, markets may still be disappointed.
Some market participants argue that QE does not matter because rates are so low. However, Fed policy via QE could replace a fear-driven flight-to-safety cause for low rates. This action also could put a floor under sentiment to prevent a self-fulfilling negative spiral. More QE could price out deflationary or "Japanification" worries as well. Another concern is that QE3 may have a diminishing marginal benefit. Chairman Ben Bernanke has acknowledged this possibility, and a recent SF Fed study found a smaller effect from QE2/OT relative to QE1, although not zero. This larger impact appears due to its size and because markets were more stressed. This argues for a sizable Fed action, especially if strains from Europe wash onto US shores, hence our call for US$800bn in purchases later this year.
Dovish downgrades
As for the meeting today, we expect the FOMC statement, released at 12:30pm to be dovish, but not to announce new easing measures. Current conditions are likely to be marked down, noting the slowdowns in hiring and consumer spending, as well as the drop in energy prices. The outlook should be more cautious, citing "significant downside risks" from Europe and the US fiscal cliff. A stronger policy commitment is also possible: instead of "is prepared" to adjust its balance sheet to support the recovery, it could say it "stands ready" and drop "as appropriate" - implying more urgency to act. We also look for downward revisions to their rate forecasts, especially by the dovish FOMC members.
Market implications
We see a disappointment from the Fed as being negative for risky assets and ironically positive for Treasuries. Implications could be muted by how dovish the statement, projections and press conference are perceived by the market, since the market may simply push out the timing of QE3. However, any extension of Operation Twist looks to us a lot less likely once it ends.