While Extending Twist, Federal Reserve Leaves Door Open for QE3

The Federal Reserve's June meeting was widely observed by market participants, with the Fed opting to extend Operation Twist throughout the year, as many expected. The Fed said it would increase the size of the program by $267 billion, or at a rate of about $45 billion per month, similar to the rate that the program had been twisting previously.

The Fed softened its tone on the strength of the economy, citing lower medium-term inflation expectations and lower resource-utilization. The Fed's language left the door open to a third round of asset purchases, commonly known as quantitative easing (QE3).

The Fed may be waiting until medium-term inflation expectations come down further, as inflation has risen modestly in the wake of previous easing programs. Market expectations of inflation can be measured by the breakeven rates on bonds: the difference in yield of nominal and inflation-protected bonds of the same maturity. The 5-year breakeven rate, comparable to market expectations of annual inflation for the next five years, currently sits near 1.85%. The Fed has only launched a new policy when this rate drops to 1.5%. Thus, inflation expectations may not have been low enough for the Fed to launch a new QE program at the June meeting.

In the Fed's forecasts, the economists and FOMC members ratcheted down inflation expectations for 2012 from an expected 1.9-2.0% at the April meeting to 1.2-1.7% at the June meeting. As the Fed lowered inflation expectations, it may be expecting a softer economy over the next few months, potentially allowing the Fed to act further if need be. The wide range of estimates is also notable, as it shows that the Fed is less certain about the next few months. The Fed's Chairman Bernanke, as the foremost scholar of the Great Depression and Japan's economic stagnation, knows the perils of deflation, and his policies over the last five years have been targeted at preventing deflation. Thus, watching inflation expectations may be key.

The Fed also has an employment mandate, in which it is expected to promote full employment alongside stable inflation. The Fed raised its forecast of the unemployment rate to 8.0-8.2% from April's forecast of 7.8-8.0%. With the unemployment rate currently at 8.1%, this forecast implies effectively no employment growth over the next six months. Thus, the Fed may also act to promote further employment gains.

There are other reasons why the Fed may be postponing any new easing measures. First, Congress has yet to resolve the "fiscal cliff"--the combination of spending cuts and the expiration of tax breaks that are set to expire at the end of the year (by some estimates, an amount totaling approximately 4% of GDP). Without any changes to current law, Congress may be set to drive the U.S. into a recession next year. Thus, Bernanke may be waiting for Congress to resolve these issues.

There are other headwinds affecting the economy. Many European economies are entering recession as a result of austerity measures used to fight the European Debt Crisis. Bernanke may be waiting for European fiscal and monetary authorities to act first, thinking that easing measures from Europe could spill over and be more effective than Fed easing. Also, a slowdown in China has been met with easing measures from the People's Bank of China and a recession in the U.K has been met with continued QE from the Bank of England.

The Fed has not decided to launch a QE3 as of yet, however they have not closed the door on the potential for one either. If anything, the lowered forecasts and softer language hint that the Fed is more concerned about the economy than previously thought. Breakeven rates may continue to move lower if inflation expectations fall. For traders who want to play the potential rate cuts in Europe and QE3 in the U.S., investors could trade the trends in the EUR/USD rate. If the European Central Bank (ECB) cuts rates in July, the EUR/USD would likely move lower. However, QE3 in the next few months from the Fed would be dollar-negative, and the EUR/USD would rally. Thus, traders could trade these moves. Also, more sophisticated traders could embark on a Double No-Touch Strategy in the 1.18-1.32 range, both major technical levels, over the next few months.