Fed Minutes hint at more QE yet its power to move the markets is waning

The U.S. Federal Reserve revealed on Wednesday the minutes from its last open market committee meeting, held on October 23-24. Investors were largely disappointed as they have been too demanding of additional monetary action to offset fiscal policy inaction. Even though the Federal Reserve continues to adopt “dovish” language, it seems that is not enough for currently running scared investors.

The Federal Reserve has been engaging in a program of swapping $45 billion of short-term Treasuries on its balance sheet for long-term debt and, as approved at the September 13 meeting, the central bank is additionally buying $40 billion in mortgage-backed securities every month for the for-seeable. The program is effectively open-ended and will continue on until there is a “significant improvement” in economic conditions.

“Operation Twist” as it has been coined is now approaching an end and will be concluded at the end of this year. Even if the Federal Reserve wants to expand it, that is not possible as the central bank has almost completely depleted its short-term Treasury holdings while unfolding the operation. With this in mind, many investors have been pointing to an expansion of the current $40 billion asset purchase program. Many see the FED engaging in a $45 billion monthly purchase of Treasuries as Operation Twist expires. If this does transpire then the FED would be purchasing a total of $85 billion in assets each month.

Although many see the extra buying as a done deal, the FED has decided to keep “mum” about such a possibility for now. Minutes from the meeting show a growing concern over the “fiscal cliff”. The committee thinks the un resolved fiscal matters pose additional risk to the nascent U.S. economic expansion as businesses are delaying hiring and investment decisions due to the uncertainty created. The FED has been giving signs that it may want to act to offset any negative effects deriving from the tax hikes and should the US go head over heels over the fiscal cliff this is likely to be the catalyst used to expand its asset purchase program as long as inflation is not seen rising above 3%.

The FED has been very busy indeed since 2008 purchasing assets. The first program started in 2008 and resulted in a total purchase of $1.25 trillion of mortgage-backed securities, $175 billion of Federal agency debt and $300 billion of Treasuries residing on their balance sheet. Over its second program, the FED purchased $600 billion of Treasuries and now it is purchasing $40 billion per month. According to San Francisco FED President, the FED may need to buy more than $600 billion in bonds, surpassing QE2.

The effects deriving from quantitative easing have been debated over the years with many stating it is not useful to the mainstream economy. There is no doubt that if the FED hadn’t done anything the stock market would not have recovered as it did and employment would be a lot worse. But, looking at Japan, there’s no doubt that effects from easing are limited when there’s too much of it on the table. The first two programs led to a decent appreciation in the stock market but now markets are down since the start of QE3. The table below shows how badly equities have been since September 13.

We can see that the main U.S. equity indices have performed very poorly with the S&P 500 down 5.64% and the Dow down 5.72% since QE3 was announced. Gold has been the best performer on the list but still was not able to avoid a loss. The US Dollar, against all expectations, has been rising. QE3 should have lead to a debasement of the currency but that hasn’t happened so far.

If we look at the table a little more closely, we understand why the FED has expressed concern about the fiscal cliff. We split the data in two sets: between QE3 announcement and the US election, and after the US election. Before the U.S. election the S&P was down just 0.60% but decreased 5.10% in just a matter of days after President Obama was re-elected. The same fate has befallen the Dow.

Although many saw the re-election of Barack Obama as a positive, concerns about the fiscal cliff are now clearly the driving force in the markets. With a Democratic President and a Republican House, negotiations on fiscal policy will be tough and investors are now anticipating what had happened in August last year with the debt ceiling issue and which resulted in a S&P downgrade of the AAA rating the U.S. had enjoyed to resurface. At this point uncertainty is growing quickly and it is really tough to trade at the moment. Spread betters without a clear conviction should reduce exposure and be vigilant. QE3 favours gold and equities but the fiscal cliff may prove the bogeyman that deflates the widely expect year end rally!