9/8/2011
By Brian Sozzi, Research Analyst

The only reason the market has not plunged into an abyss is that investors continue to look forward to a revival of extraordinary Fed accommodation.  If Bernanke were to state today there are still too many risks to implementing a range of tools (or specific tool) to improve execution on the Fed's dual mandate, the market would head right back to the August 8 lows.  I wonder if that hypothetical retest would not be healthy, finally depicting valuations as to where the economy is rather than it artificially could be under the thumb of the Fed.  The quicker the market is allowed to function on its own, the quicker we perhaps exit the grips of the Great Recession once and for all.

We have to deal in the known knowns, however.  The known knowns at the moment include:

* There is an atypical FOMC meeting around the corner, and it's difficult to think investors will leave empty-handed by the Helicopter Ben Bernanke led Fed.

* Mixed economic data, which has begun to surface from outright dour in August, is not enough to create the number of jobs needed to meaningfully reduce the unemployment rate and spark healthy levels of inflation.

* Chairman Bernanke still has broad support inside the FOMC and by his comments since Jackson Hole, he sees economic output as weak enough to warrant additional action.

So what is the Fed likely to do?  There are three things on the table as far as I could see:

Operation Twist: Remember these two words for they will become commonplace in the WSJ into the end of the year.  Basically, the program is where the Fed buys long-dated Treasuries to bring down interest rates to spur economic activity (refinancing, home buying, etc.).  OT2, as I am calling it as the Fed did it before in the 1960s, may be ineffective according to Pimco's Bill Gross in a very detailed Financial Times op-ed yesterday.

Operation Inflation: Fed would reduce or eliminate a 0.25% interest rate it currently pays banks that keep cash on reserve with the central bank.  I view this as very dangerous, potentially creating bubbles in many asset classes.

Operation Jawbone: The use of highly specific language by Fed officials to express policy objectives, say as it pertains to inflation targeting or caps on medium-term rates.  I think the market wants action this time around, not lip service.

Brian Sozzi
Wall Street Strategies

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