What to Expect from Bernanke and the FOMC Announcement

The FOMC began its two day meeting this morning and will make its announcement on monetary policy tomorrow (Wednesday) at 2:15pm EST.

I am expecting volatility following the announcement. It is a gamblers game to try and predict how the market will react, but often times the initial move is the false move and will be followed by a reversal. We already know what the Fed's longer-term game plan is. To put it simply, the Fed wants to keep interest rates low and devalue the US dollar. This is nothing new. Low interest rates encourage spending and a devalued dollar makes US exports more affordable for foreign importers. This in theory will increase employment and stimulate the economy. At the same time it will decrease the existing US debt by essentially making that debt worthless. If the dollar is worth half as much as it once was, that makes the debt only half as large as it should be. This is good for an insolvent government, but bad for its people as their ability to purchase real assets decreases.

That describes what the Fed wants to do. Now the question is what will they actually announce tomorrow?

OPTION A)
More Stimulus in the form of a QE3 type of measure:
There are some economic conditions, at present, that could warrant this type of action. The US has seen zero job growth and flat retail sales in August. Commodity prices seem to be in a downtrend which provides additional support that inflation is not a problem. That being said, I don't see QE3 (or something similar) as an option. Expanding the balance sheet to buy more bonds will send more money into the precious metals market and drive commodity prices higher. The Fed and Central Banks around the world do not want to see the price of Gold increase further. They want to continue to deceive the uninformed public that fiat currency is legitimate tender. Depreciating currencies will eventually lead to the adoption of a gold standard or something like it and that would prevent the Central Banks from being able to print money at will. QE1 and QE2 can already be viewed as failures and launching a QE3 now would be ill-advised. It will likely happen down the road, but the time is not now.

OPTION B)
The Fed will announce a plan to sell short-maturity Treasury debt and use the proceeds to buy longer-term bonds:
This is what many expect the Fed to do, an action popularly coined "Operation Twist" because the goal is to bend the yield curve. Currently the yield curve shows 3 month treasury yields at 0.1% and 30 year yields at 3.2%. By selling short-term bonds and buying longer-term bonds, the Fed will attempt to flatten the yield curve. Flat yield curves generally precede economic slowdowns, but low yields across the board generally promote spending through borrowing. So in reality, "Operation Twist" seems more like rhetoric from the Fed than anything else. In any case, unlike quantitative easing or QE, the "Twist" (good or bad) can be done without increasing the money supply.

Implementation of "Operation Twist" alone should not have a large effect on the markets. In fact, that news alone would likely send the markets lower as I believe it is already priced in. The FOMC's 2-day meeting is a break from the standard 1 day meeting and suggests that the Fed has something else up its sleeve...

What else could the Fed do?
Below I have included some additional options (taken from David Rosenberg and commented on by Mish Shedlock):
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1. Eliminate the interest paid to commercial banks on excess reserves (to try to spur lending).
   
2. Announce an explicit ceiling on the 10-year note yield (say 1.5%), which the Fed has done in the distant past. Based on Bernanke's prior rhetoric, this would seem to be a preferred strategy (though the Fed relinquishes control of the balance sheet).
   
3. Buy foreign securities (bail out Europe and weaken the U.S. dollar — talk about killing two birds with one policy stone).
   
4. Announce an explicit higher inflation target or perhaps a lower unemployment rate target (i.e. reinforce the DUAL mandate).
   
5. As Mr. Bernanke stated for the record in November 2002, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. It could offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector.
   

Read Mish's entire article here.
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Whatever the Fed announces, expect volatility. I will most likely stay away from trading the initial reaction. For me it is best to try and digest the announcement and wait for the market to settle down and give a more realistic indication of the next direction.

What I foresee is initial selling pressure that could take the markets down significantly. This will signal a buy entry for me as I believe the goal of whatever the Fed announces will be to stimulate the markets. We'll have to wait and see what unfolds tomorrow... Could be some fireworks...