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The Federal Reserve left the Fed funds rate unchanged at 0.25%, in line with expectations. As the market expected, the Fed extended Operation Twist, its bond buying program selling shorter-duration securities for longer ones, by declaring its intention to purchase Treasury securities with remaining maturities of 6 years to 30 years at the current pace and to sell or redeem an equal amount of Treasury securities with remaining maturities of approximately 3 years or less.
A more dovish tone
The tone of the Feds latest statement was more dovish, extending its low interest policies, pointing out that employment and household consumption growth has slowed in recent months and reflected a modest downgrade in the Feds quarterly forecasts. In addition, the Fed recognized the fall in oil and gas prices has led to a deceleration in consumer price inflation.
Notably, the Fed left the door open to QE3 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.”
QE3 not a slam dunk
As the markets digest the news that an imminent round of QE3 is not in the works, there is bound to be disappointment. The Fed used the cautionary customary language that it was prepared to act should economic activity falter or unemployment increase. The Fed states it is prepared to take action. However, we are not convinced it is significantly closer to pulling the trigger on QE3. Why?
- While the macro data has slowed from surprising strength in Q4/Q1, it is expanding close to trend in Q2 at around 2%. The distortions from record warm weather make it difficult to determine if the economy is slowing in a material way.
- The Feds measure of inflation expectations remains surprisingly stable at around 2.5% towards the middle of its range since September 2011. Certainly it is not hinting at an upcoming bout of deflation.
- Labor indicators remain somewhat stable with jobless claims edging higher but not to the same extent as in Q2 2011 – which signaled a pronounced slowdown in economic activity.
Market Implications: Risks of a disappointment
With the high frequency U.S. macro economic reporting coming in weaker than expected and a slew of Fed speakers opening the door to some form of unconventional monetary action, market expectations for Fed action were quite high.
As the accompanying chart shows, the market priced in an approximately 70% chance of unconventional monetary easing.
Source: Pioneer Investments, BofA Merrill Lynch Global Research. Weighted Spread between inflation breakeven and real rates. Last data point 6/18/12.
In addition, this was supported by the price action in equity and fixed income securities. US equity markets have rallied strongly in June with the S&P 500 rising 6% while conversely 10 year yields rose 20bp. With the Fed delivering on what the market was expecting, it is no surprise that the knee-jerk reaction on risky assets were largely muted. However, to the extent that there were investors expecting QE3, there is risk of a sell-off in the coming days. This may ensure that rates remain pinned towards recent lows.
The U.S. dollar rising or falling in relation to other currencies will largely take its cue from the price action in risky assets. If equity prices and risky assets as a whole come under pressure, the USD is likely to appreciate.