Diary of a Financier

SPX Update & Fed FOMC Pregame: “OT2-lite” to Underwhelm at First

In Capital Markets, Economics on Wed 20 Jun 2012 at 09:18

I expect Fed will announce an extension to Operation Twist this afternoon at 12:30 EST, the conclusion of their June 18-19 FOMC meeting. They’ll extend the program on an indefinite basis, and they’ll couple that with an extension of their ZIRP language through 2015. This is an underwhelming result for a market that’s rallied for hope of something more.

$200b in short-term (1-3 year) securities still exist on the Fed’s balance sheet. Cleaning out their inventory risks losing control of the front-end of the yield curve. Therefore, I suspect the FOMC will extend the ZIRP promise through 2015 (previously 2014). In Ben Bernanke’s mind, this measure should help pin short-term rates without the Fed there to soak up supply. I want to note the pitfall of this strategy, were Mr. Bernanke’s Fed to depend on it as a ZIRP stand-in. In practice, is more of a placebo: with every passing day, part of the yield curve would unhinge from ZIRP as more maturities from newly issued CUSIPs will fall beyond that 2015 reach. For example, a year from now, the on-the-run 3-year Treasury would mature outside the ZIRP regime. It’d be interesting to see whether the curve steepens or low coupons (high duration) emerge from such new-issue auctions. A zero-bound Fed Funds Rate would keep nominal rates at zero But, were the Fed to vacate maturities on the front-end altogether, real rates could run higher, escaping from their current, sub-zero standing–as prescribed by the Taylor Rule.

I also see the FOMC agreeing to resume a flow of ~$40b in monthly Twisting and vote whether or not to extend the operation at every subsequent monthly meeting. I’m dubbing the program “OT2-lite.” At $40b/month with only $200b in supply left, the Fed can extend this operation no longer than 5 or 6 months.¹

This combine approach is the smallest common denominator among the Fed’s voting governors: it appeases both the doves and the hawks. The former want to preempt any double-dip with gratuitous liquidity. Tha latter think the record 1q12 warm weather pulled-forward demand from 2q, which will normalize to trend growth in 3q. One party is composed of academics who fear irreversible deflation; the other of empiricists whose regional constituencies despise inflation. OT2-lite is a modest compromise between these voting factions.

The US market has priced-in an expectation for something more than a traditional OT2. Comments by John Hilsenrath (The Wall Street Journal’s mole to the Fed), SocGen, and Goldman Sachs have propelled the QE3 hype. If disappointed, SPX will pullback and wait for bullish material out of Europe later this week. My base-case expectation (OT2-lite) is a climax that underwhelms this prevailing consensus.


In accordance with my analysis of market bottoms earlier this month, I still see the S&P 500 (SPX) in an inverted Head & Shoulders bottoming process.² I can confidently lump the 2012 SPX correction together with the others since 2008–all three of which ended in an inverted H&S bottom. Today’s bottom has occurred on a condensed timeframe compared to historical norms, which does mess with the coordination of longer fractals, specifically the monthly’s indicators. That’s fine, although it weakens my confidence in the analogue’s integrity.

The 2010 & 2011 H&S bottoms provide the best fit for today’s market. I note the neat alignment of all pricetrend fractals, in addition to daily & weekly indicators. Again, the monthly’s stochastic reflects the condensed nature of the peak-to-trough correction, attributable to Ben Bernanke making good on his promise for preemptive action:

ES H&S Bottoms Analogue (daily/weekly/monthly)

The yellow, vertical lines in that chart are my attempt to pinpoint our relative progression through the analogue. They all portend a pullback here proximately, a convenient alignment given my intimation that OT2-lite will disappoint.

I also used Fibonacci levels to supplement those heuristic calls. The 61.8% retracement is where the recovery rally usually reverses into its right shoulder, one last dip before retuning to trend growth:

ES H&S Bottoms Analogue (Fib Levels)- 61.8% retracement resistance triggers one last reversal.

Premarket this morning, SPX ~1358 is just shy of that ~1360 resistance. This is certainly one of those “buy the dip” instances, with SPX 1300 (Fibonacci 23.6%) my right shoulder target at which I’ll deploy a good portion of my 23% cash toward index exposure.


¹Fed’s balance of short-term assets totals ~$200b, but OT2 gross notional POMO activity could total ~$240b considering interest in-flows and the purchasing of higher price, longer-term assets.

²Recall that I wrongly expected a reversal in a classic bear flag to prevail over the bull inverted H&S.

N.B.- I’m retracting one of my StockTwits from yesterday, which nominated 2011 (12/7/11) as the best-fit analogue. My subsequent analysis nominated 10/24/11 as more appropriate.

  1. Full Text: http://www.businessinsider.com/fomc-interest-rate-decision-2012-6

    Key Take Aways:

    1. Fed expects economic growth to remain moderate over coming quarters and then to pick up very gradually.

    2. Keep the target range for the federal funds rate at 0 to 1/4 percent

    3. Expand Operation Twist by $267 billion through the end of the year:
    – Buy Treasuries with maturing in 6 years to 30 years
    – Sell Treasuries maturing in 3 years or less.

    4. Reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.

  2. […] the 30-minute intraday S&P 500 ETF (SPY) frames the inverted H&S bottom I’ve been squawking about so much since the beginning of this month. Recall, this chart […]

  3. […] maintain my intermediate-term bullishness for a number of reasons.  Among these reasons, the 2011 analogue suggests SPX will resume a cyclical bull rally once it hits support here.  Plus, the longer-term […]

  4. […] to underestimate the reflationary potential of the ECB’s rate easing/growth pledges, the Fed’s OT2-lite, the BOEs renewed QE, the BOJ, PBOC, SNB, et al.  These things take time to work their way […]


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