Trading, With a Twist

 | Sep 21, 2011 | 8:43 AM EDT
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"The U.S. government has a technology, called a printing press (or today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at no cost." Ben Bernanke

In late August 2010, Federal Reserve Chairman Ben Bernanke announced the central bank's second quantitative easing program.

The goal of the program was to pour cheap cash into global financial markets to inflate asset prices. The logic was that when the stock markets rises and asset prices go up, people will be more confident because they will feel wealthier. If people feel wealthier and more confident, they will spend more money and take greater risks, which will boost the economy and create positive momentum.

That is the theory, and it worked pretty well as far as inflating asset prices. The market went almost straight up for seven months following the announcement of QE2. It was one of the most lopsided runs we've had in the market in quite some time.

Unfortunately, QE2 was not nearly as successful restoring confidence and inducing people to spend, invest and take risks. The economy remains in the doldrums and many economists are wondering if further quantitative easing is going to be of any consequence.

At 2:15 p.m. EDT today, we will likely find out if the Fed plans to give quantitative easing another try. It is widely anticipated that the Fed will announce Operation Twist, which is designed to twist the yield curve by pushing down long-term interest rates. Since short-term rates are already near zero, more cheap money won't have much impact unless it has a longer duration.

While few market players believe we will see the market respond to QE3 the same way it did to QE2, there is a large faction who live the old adage that you can't fight the Fed. Even though QE2 was ineffective in many ways, it did boost the market substantially, and many folks will be hoping and betting that Operation Twist will do the same.

The market action over the past week suggests that expectations are quite high that the Fed is going to announce its next quantitative easing program this afternoon, or at least hint at it. Some economists believe the Fed still wants to see more data and will wait, which is likely to disappoint the market.

The dilemma for the market is that conditions are quite different than they were a year ago, and quantitative easing is unlikely to have the same impact. Interest rates are already low and it is clear that cheap money is not doing much to help the economy. In addition, the potential for inflation grows the longer the Fed attempts to keep rates artificially low.

On the other hand, if the Fed creates more cheap money, that money has to go somewhere, and the most likely place is the stock market. That may not help the economy much but it may make investors happy if quantitative easing takes hold like it did a year ago.

It is up to the Fed now. If the Fed doesn't announce Operation Twist, it is likely to cause disappointment. If the Fed does announce Twist, it's already been anticipated to some degree but will likely cause some squeezing and bring in buyers who anticipate a move like last fall.

The market is not particularly healthy right now, although we have had a substantial rally. It has been an extremely narrow advance with a small group of big-cap momentum names driving the action while most of market has struggled. The market is running into technical resistance and is a bit overbought. It is not a great foundation for further upside, but it has not paid to underestimate the power of the Fed.

I don't plan to make any big bets in front of the Fed news, but I will be looking to play the reaction. We are likely to see a high level of volatility following the news, and I'll be focused on finding opportunities at that point.

Strap on your trading helmet, it should be a very interesting day.

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