Market Overview

Federal Reserve to Unveil New Easing Measures on Wednesday?

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The Federal Reserve will conclude its two-day meeting on June 20. With a slowing global economy, stagnant employment growth in the U.S., and a worsening European Debt Crisis, many traders are anticipating action.

Economists and analysts were calling for the Fed to embark on further easing, either extending the current liquidity operations commonly known as Operation Twist or embarking on further easing via the Large Scale Asset Purchase (LSAP) program. With commodities such as WTI oil near their lowest levels since April, disinflationary pressures were reigning Tuesday. These pressures caused some to call for further Fed easing.

Economists at Credit Suisse expected an extension of the current Operation Twist over the next few months, citing that the Fed will most likely take a wait-and-see stance in its policy. Further quantitative easing, which does not include an Operation Twist extension, would likely be inflationary and thus likely increase oil prices. The Fed might not want to be seen sending oil prices to new highs and gas prices with it, which could cripple the US economy.

Alternatively, Jan Hatzius of Goldman Sachs said the Fed could embark on a "Flow" program, in which it would pledge to print roughly $50-75 billion per month until it sees improvement in the economy.

With many investors already predicting an extension of Operation Twist, this Fed response might already have been incorporated into equity prices. If an extension of Operation Twist has been incorporated into stock prices, a full-scale LSAP expansion might be the only Fed response that would send financial markets higher.

Trading the June 20 Fed Statement

In preparing for the Fed, investors and traders alike need look no further than three simple, liquid assets.

First, investors should consider trading U.S. Treasury bonds around the time of the Fed statement during the afternoon of June 20. The below chart, courtesy of Bloomberg, shows that the price of the benchmark 10-year bond was rather volatile surrounding the release of the Fed's April statement. So, traders may be able to capitalize on similar volatility surrounding the June 20 statement. The pattern appears to be that the market overshoots a target and then reverses. While individual investors may not be able to beat high-speed traders on the initial moves, they can prepare with limit orders to catch the risk-reversal.

Second, investors might watch gold and, more broadly, metals. Gold has rallied in the wake of the financial crisis, as the devaluation of fiat (paper, non-metal backed) currencies has led to an appreciation, known as the reflation, of hard assets. Gold has gone from some $600/oz in 2008 to well over $1600/oz Tuesday, fueled largely by the balance sheet expansion of central banks. If the Fed decides to embark on new easing measures via the LSAP, gold would likely rally. However, an extension of the twist may be viewed by gold and other metals markets as a letdown, triggering a gold selloff. In August and September of 2011, hopes of another round of quantitative easing via the LSAP drove gold above $1900/oz, before the yellow metal fell precipitously. Investors might expect a similar pattern to continue. Purchasing gold before the Fed's June 20 statement may be a bet on future balance sheet expansion, rather than a continuation of Operation Twist.

Third, surrounding the Fed's June 20 announcement, investors might also watch the U.S. dollar and, more broadly, currencies as a whole. The dollar will likely fluctuate around the press release, given that any balance sheet expansion would likely equate to a direct devaluation of the greenback. The dollar would presumably sell off against other currencies should Chairman Bernanke announce some new round of quantitative easing. However, Operation Twist is a so-called balance sheet neutral operation, meaning it does not increase the size of the Fed's balance sheet, and thus would probably drive those who are short the dollar (in anticipation of QE3) to cover and cause the dollar to rally. Investors looking to take a dollar position against other currencies can utilize the PowerShares DB US Dollar Index Bullish ETF (NYSE: UUP) or the PowerShares DB US Dollar Index Bearish ETF (NYSE: UDN).

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