The Overnight Report: Like We Did Last Summer

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By Greg Peel

The Dow closed down 283 points or 2.5% while the S&P lost 2.9% to 1166 and the Nasdaq fell 2.0%.

As was correctly anticipated by the market, last night the Fed announced it would sell US$400bn of its Treasury holdings of three year maturities and below and buy US$400bn of maturities in the 6-30 year range with an average duration of 12.9 years. It's not the Fed's label, but this has been dubbed “Operation Twist” because that's what the strategy was called in 1961 – the last time the central bank implemented such a strategy.

In 1961 the Dow was 700 when the Twist was applied and by 1965 it was 1000. That might sound encouraging, except that the Dow spent the next 16 years oscillating in a range of roughly 700-1000. Only in 1982 did it break out. Can we make a comparison to those far off times?

As is typical on the release of a Fed statement, traders tried to act quickly before they'd even read the whole document. The Dow jumped very briefly at 2.15pm, then spiked down, then rallied briefly, then plunged. One might argue this is because a Twist does not constitute actually quantitative easing. Wall Street did not get QE3. But then if every man and his dog was anticipating a Twist in place of QE3, why such negativity?

The answer might be that traders went straight to the important policy strategy paragraph before they looked closely at the previous paragraph. At its last meeting in August, at which the Fed announced its fund rate would be zero for two years, the assessment was that “downside risks to the economic outlook have increased”. Last night's statement declared “there are significant downside risks to the economic outlook, including strains in financial markets”.

On Tuesday it was the IMF downgrading its global economic forecasts, and last night it was the Fed. The IMF is always miles behind the curve so can be quickly dismissed, but even in the Fed's case one can still say “thanks Scoop”. Hands up anyone who hasn't felt over the past couple of months that the economy was facing significant downside risks or that financial markets were becoming strained. Anyone? Anyone? Bueller?

The result was nevertheless a sharp sell-off in which buyers stood aside and computers led the charge. There is a general feeling that Operation Twist does not do enough, particularly if downside risk is now “significant”, and that really the Fed is just hand balling the problem back to Washington. Bernanke has indicated often enough lately that it's up to Congress to sort itself out and agree to positive fiscal measures. The Fed is not going to carry the can alone. Instead, the Fed will concentrate on mortgages by lowering the long-end yield as well as reinvesting the expiring mortgage securities and Fannie and Freddie agency paper it has on its balance sheet.

It's all well and good, but the US thirty-year yield is already near all time lows. Mortgage rates have never been lower (outside of the post GFC period), but banks are very wary of who they lend to, what their job is and just what sort of deposit they can put up. Wall Street can't really see Chubby Checker leading the US economy out of the wilderness. With all that is going on in Europe, something more aggressive would have been better received.

It has nevertheless been the trend of late, when the Fed announces a major policy change, that Wall Street reacts strongly in one direction in the last hour or so of the session, thinks about it overnight, and then comes back and goes the other way the next day. Plenty of smart traders simply stay out of the initial mayhem. As to whether that will be the case tonight remains to be seen. In the meantime, the US bond market was quick to make the relevant adjustments.

The two-year yield rose 3 basis points to 0.20%, the ten-year yield fell 8 basis points to 1.87%, and the thirty-year yield fell 21 basis points to 2.99%. The Fed is forcing a flattening of the yield curve in order to make mortgages cheaper, but as noted the banks still have to be willing to lend the money. Banks need to be able to borrow cheap and lend dear to operate, and a flat yield curve kills off their margins. Financial stocks were amongst the hardest hit last night. Never mind that the banks are still holding vast amounts of cash on deposit at the Fed earning interest. The Fed has previously noted the option of dropping that interest rate to zero (or perhaps lower) but has yet to play that trump card. Maybe Bernanke's saving that one up as he puts the pressure back on Congress.

The Twist is also positive for the US dollar, and it rose 1.1% to 77.80 on its index. A strong dollar is bad for commodities, so gold fell US$22.80 to US$1782.00/oz. Nickel, tin and lead all dropped 3% while the other base metals were steady, but the last trades on the LME occurred 15 minutes after the Fed statement. West Texas crude fell US$1.00 to US$85.92/bbl while Brent fell only US18c to US$110.36/bbl.

The Aussie commodity currency plunged over two cents to US$1.0042.

The SPI Overnight fell 105 points or 2.6%. Subtract 105 from yesterday's close in the ASX 200 at 4071 and you get 3966. The August low was 3986.

The world is facing a crisis of confidence. The debt problems of 2008 have not gone away, just resurfaced in the form of public debt which is controlled by politicians. Seventeen governments can't reach an agreement in Europe. One government can't find consensus in the US. The World's Greatest Treasurer spends all of his waking hours arguing about half a dozen refugees. The central banks of the world are saying to politicians: you get your own house in order first.

Is it any wonder.

Around and around and up and down we go.

One observation to make about the Fed's new policy is that the flatter the yield curve, the more valuable the yield from stock dividends. Dividend stocks had already become the investor's choice in the US and after last night they are even more so. In Australia there are also plenty of opportunities to earn an attractive margin over fixed interest as well.

Would Woolworths ((WOW)) fit into that category? Tune in at 4.30pm today for FNArena's Market Insight. Just click on the box on the website with the picture of the handsome bloke and Rudi. 

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