Note: This post will be updated through Wednesday as relevant commentary is released.
On Wednesday, the Federal Reserve will announce its latest decision on monetary policy, followed by a press conference featuring Fed Chairman Ben Bernanke.
The FOMC has a big decision to make. Last fall, it announced Operation Twist, an asset purchase program wherein the central bank buys $45 billion of long-term Treasury bonds each month and sells short-term notes to "sterilize" the purchases by keeping the overall size of the central bank's balance sheet the same.
In September, the FOMC announced open-ended QE3, which added $40 billion per month of purchases of mortgage-backed securities to the Fed's balance sheet expansion efforts.
Now, the Fed has run out of short-term notes to sell, and Operation Twist is set to expire at year-end.
The Fed's decision on what to do next will set the tone for monetary policy in 2013.
Wall Street economists expect the Fed to fill the hole left by the expiration of Operation Twist by continuing to by the same amount – $45 billion per month – of long-dated Treasuries, just without the sterilization.
Going forward, the unsterilized $45 billion per month of Treasury purchases is expected to be open-ended as well – causing a few economists, like Maury Harris of UBS and Deutsche Bank's Joe LaVorgna, to call the pending FOMC decision "QE4."
As UBS economist Drew Matus notes, "QE4 will result in a doubling of the expansion rate of the Fed’s balance sheet."
Furthermore, as shown in the chart below, the percentage of the Treasury market owned by the Federal Reserve in notional terms will begin to rise sharply after being held fairly constant throughout Operation Twist.
Anything less than $45 billion in Treasury purchases from the Fed, most economists say, would not be enough to support risk appetite in financial markets.
Societe Generale economist Aneta Markowska notes St. Louis Fed president James Bullard's remarks last week that the Fed could scale purchases back to $25 billion a month. However, she thinks this is unlikely because "the market is already priced for something closer to $40bn, hence any reduction in the pace of buying would induce a backup in bond yields, and hence constitute a de facto tightening."
If the consensus projections for the introduction of QE4 are correct, then the biggest open question headed into Wednesday's FOMC meeting is which maturities of Treasury bonds the Fed will focus on going forward.
With Operation Twist, the Fed is buying bonds in the 6-30 year range. BofA rates strategist Shyam Rajan expects
BofA rates strategist Shyam Rajan thinks the Fed could expand its purchases to include maturities as short as 4.5 years. In a note to clients, he writes:
The Fed has some room to shorten its duration of purchases since the new program will no longer involve sales. Purchases during Operation Twist had an average duration of about 10 to 11 years, while the sales reduced the net duration taken out in the program by about 1.5 years. Since further purchases would no longer involve sales, the Fed can shorten its purchase bucket modestly while maintaining the same duration impact.
Hence we expect the shortest maturity purchased in the new program to be extended to include the 5y sector, in our view. Technically, the purchase buckets may start from the 4.5y sector so as to include the new 5y note (barring which the newly issued 5y note would never be eligible for purchase since it would have rolled down to a shorter maturity). The inclusion of the 5y sector would help convey a large capacity for open ended purchases by including a bucket where a sizeable portion of gross issuance is concentrated.
Fiscal cliff concerns
Then, there is the issue of the fiscal cliff. Citi economist Robert DiClemente begins his latest note, "This may be a question for philosophers, but if the FOMC were to ease monetary policy on a fiscal cliff, would it make a difference?"
Whether QE4 would be enough to offset the negative economic effects of going over the fiscal cliff or not is an open question, but one area where it would make a big difference is in the Treasury market, because going over the fiscal cliff would entail a sharp drop-off in long-term debt issuance from the U.S. Treasury.
SocGen fixed income strategist Mary Beth Fisher calls this "the real gasoline on a fire scenario" in a note to clients entitled December Is About to Get Interesting:
The real “gasoline on a fire” scenario, as far as the Treasury market is concerned, is if the Fed firmly commits to a new unsterilized, large-scale Treasury buying program, and then the fiscal cliff resolution produces a large drop in the 2013 deficit. Should Congress and the Administration not negotiate a new agreement, that will in fact be the outcome under current law.
This would de facto result in significantly smaller Treasury supply going forward. If the Fed chooses to “hoover up” the vast majority of that supply, as it is doing with new origination agency MBS, the 10-year Treasury could be on a path to 1.00%.
FOMC economic projections
Another topic in focus at Wednesday's FOMC meeting and Bernanke's press conference will be the Federal Reserve's newly-updated economic projections.
Deutsche Bank economist Joe LaVorgna says that Friday's stronger payrolls numbers will not deter the Fed from a strong easing stance. He cites the civilian employment to population ratio, which has fallen slightly, as a key reason why " dovish policymakers will be un-swayed by recent labor market developments."
And SocGen economist Aneta Markowska says that the Fed's " 2013 GDP forecast published in September still looks relatively high at 2.5%-3% and is at risk of being revised lower."
While BofA's Michael Hanson, Priya Misra, and John Shin don't see much scope for forecast revisions, they say there is something else the Fed could do to "innovate" at this meeting with regard to forecasting:
At this meeting the FOMC economic projections will also be updated, but we do not expect sizable forecast revisions given the macro uncertainties. One potential innovation, mentioned by Vice Chair Janet Yellen, would be to list joint economic and policy forecasts — that is, grouped by FOMC member, without identifying each forecaster. That way, the market could better distinguish a long policy hold past the onset of the recovery — which is what the FOMC committed to in September — from a less optimistic outlook warranting even more easing.
The Federal Reserve announces the outcome of its December FOMC meeting on Wednesday, December 12 at 12:30 PM ET, followed by the release of its economic and Fed funds rate forecasts at 2 PM.
At 2:15 PM, Fed Chairman Ben Bernanke will begin a press conference to discuss the decision. Follow all of the developments LIVE on Money Game >
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