Markets React to the Fed's Newest Form of Intervention

Confidence down. Stocks downer. Gold downest.

Gold, as Fellow Reckoners have no doubt observed, is off big time today. The Midas metal has tumbled almost $100 in the past 24 hours. As of this writing, an ounce trades for about $1,638…although that figure is likely to be outdated by the time you read this. For perspective, the $1,650 mark was celebrated as an all-time nominal high just a month and a half ago. What a change six weeks can make.

Stocks, similarly, are suffering. The Dow has shed almost 800 points this week; 650 of them since B.S. Bernanke and the Fed announced its Operation Twist program a couple of days ago.

So, what’s happened? It’s more of the same from the Fed, right? Why the long face? Was it because it wasn’t enough of more of the same?

“The stock market threw a tantrum after the Fed announcement, because on the surface, the decision seems tame compared to past Fed actions,” explains our short selling maven, Dan Amoss, in a note carried in today’s edition of The 5-Minute Forecast. “Also, Operation Twist will shrink the profit margin on the Wall Street banks’ carry trades. But there is more than meets the eye.”

Dan laid out three important effects the Fed’s latest move will likely have on both markets and the economy in his note. Here they are:

1) As with QE2, the Fed will continue to make it painful for institutional investors to own Treasuries. In the Fed’s mind, low yields will force savers and investors to speculate in riskier assets like junk bonds and stocks. The effect of this will probably be weaker than it was during QE2, and the rally in stocks this time should be concentrated in fewer sectors: resources and metals mining, to name a few. Plus, earnings multiples for most stocks will over time contract as investor expectations for future GDP growth dwindle. We probably won’t see a broad market rally, but there is much more support under the market than there was in 2008.

2) The Fed’s new commitment to reinvest prepayments from the mortgage-back security portfolio may ultimately be combined with a “streamlined refinance” policy from the Treasury Department (this would have to involve waiving home appraisals for underwater, yet performing mortgages). If so, this would result in a large decrease in the yield on the Fed’s MBS portfolio, with the benefit of lower mortgage rates going toward lower monthly mortgage payments for households that have managed to keep current on their obligations.

3) Much has been written about how Operation Twist 2 will kill the big banks’ margins on Treasury carry trades, but this is offset by greater clarity about future Fed policy. Greater clarity about where short-term (and long-term) rates will be in a few years will embolden the Wall Street primary dealers to lever up carry trades and repurchase activity to unseen heights. Higher leverage in trading can offset lower net interest margins. Banks that play along by levering up the most will benefit the most. Perhaps the Fed may ultimately decide to cap the 10-year yield, and print as much money as necessary to defend that yield (including taking foreign creditors out of their Treasury positions if they so choose).

Hmmm…a program that punishes savers, encourages speculation and rewards well-connected banks for jacking up leverage. Yep, sounds like a Fed-sponsored operation to us.

“Ultimately,” continued Dan, “these inflationary policies will backfire, and the Fed will lose its remaining credibility. You can imagine how the supply side of the economy will react. This is a theme I’ve been highlighting since the launch of QE2: the steady revulsion of the dollar by producers. The demand for dollars among more and more producers will fall, and the demand for precious metals and in-ground resources will rise.

“I don’t think any of these factors are healthy for the long-run stability of the global economy,” Dan concluded. “But as investors, we have to deal with the reality we face, not the one we may wish for.”

Joel Bowman

for The Daily Reckoning