Ask anyone one on the street whether the U.S. economy could use a jolt of stimulus and the answer will be an overwhelming YES! The labor market, housing market and the stock market is in terrible shape and if Europe continues to wreck havoc on global demand, the meager amount of growth that the U.S. economy enjoyed this past year will become nonexistent. Yet the leadership at the Federal Reserve refuses to admit that more needs to be done even though the weak data points are staring at us in the face. The S&P 500 has fallen 7 percent since the beginning of May. In the month of April, the U.S. economy added 77k jobs and last month, job growth slowed to 69k. As a result, the unemployment rate ticked up to 8.2 percent. Instead of acknowledging this deterioration, Bernanke tried to chalk it up to the weather.

Why in the world would be Fed hold back now when the labor market has taken a turn for the worse?

Here are 3 reasons:

#1 – Despite the 25% fall in oil prices since February, inflation expectations haven’t declined materially because investors actually expect the Fed to increase stimulus.

#2 – Even with the pullback in the labor market, consumer spending remains firm and there is enough positive economic data to justify saving their bullets for a more desperate time in U.S. economy. In other words, there is no need to bring out the big guns quite yet.

#3 – There have also been many disputes over the effectiveness of Quantitative Easing (What is Quantitative Easing?). The Fed argues that QE1 and QE2 eased credit, boosted growth and consumption and slowed the decline in U.S. stocks. But Quantitative Easing failed to revive the economy and QE2 was less than effective than QE1 while more QE could stoke inflationary pressures in the future.

“80% Chance that the Fed will have to resort to QE3 sometime this year – it may not be this Wednesday but it will be in 2012.

But if Europe’s problems continue to pressure the financial markets and unemployment refuses to decline, the Federal Reserve could find themselves with their back to the Wall and no choice but to introduce another round of asset purchases. We believe there is an 80 percent chance that the Fed will have to resort to QE3 sometime this year – it may not be this Wednesday but it will be in 2012. If Bernanke truly believes that the warmer weather artificially pushed up job growth in the winter, leading to a retracement in spring, then he will want to see another month of non-farm payrolls before making a decision about QE3.

The Compromise – Extending Operation Twist

However Bernanke won’t leave us completely empty handed on Wednesday. Ten days after the FOMC meeting, Operation Twist (What is Operation Twist?) is scheduled to expire. Given the weakness of the labor market, there is a 99 percent chance that Bernanke will continue to do the twist for another 6 months. If you don’t remember, that involves selling short term bonds and buying long term bonds to keep yields low. Last week, the second most powerful person at the Fed, Janet Yellen, Vice Chair of the Federal Reserve Board of Governors said point blank that “If the (Fed) judges that the recovery is proceeding at an insufficient pace, we could undertake portfolio actions, such as additional asset purchases (QE3) or a further maturity-extension program (Operation Twist).” Given Bernanke’s skepticism about the need for QE3, Operation Twist would be the best compromise. This way the market won’t leave empty handed and the Fed won’t have to show all of its cards.

But Doing Twist Alone Won’t be Enough

The key question then becomes whether Operation Twist will be enough to satisfy the market and the clues will lie in Bernanke’s post monetary policy meeting press conference. If he hints that Operation Twist is the first step to more stimulus then equities and currencies will rally. The U.S. dollar will weaken but for good reasons and no one will complain about it. If Bernanke extends Operation Twist but remains noncommittal about the need for more policy accommodation, which is the most likely scenario, investors will bid up the dollar in disappointment. We’re hoping that Bernanke won’t cause more confusion than clarity like he did back in April but given his track record of putting his foot in his mouth we’re not too optimistic.

Investors should expect it to be a VERY busy week in the forex market, with G20 leaders meeting right before the Fed announcement.

Here’s a look at how the EUR/USD, S&P 500 and US 10 year yields performed after the first and second round of Quantitative Easing. As you can see, all 3 increased when QE began and trailed off near the end

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