Can the Market Bounce Survive No Action by the Fed?

The S&P 500 has rebounded off its 200-day moving average, and has breached its still-declining 50-day moving average. All major U.S. equity benchmarks are showing the same movement as the S&P. Within the S&P 500, only the energy sector is not breaching its 50-day MA and remains well below its 200-day MA. The VIX is back under 20, the U.S. dollar index (UUP) has been falling all June, and 10-year treasury yields are in an up-tick. The question is, can this budding recovery rally survive a non-event Fed meeting when expectations of further action by the Fed are visible? Anticipation is apparently high that the Federal Reserve will announce some new step to try to rejuvenate the U.S. economy and boost investor confidence.

The options on the table are, a) extend Operation Twist, b) indicate preparations for QE3, c) stress readiness to do more, but do nothing for now.  Ben Bernanke and other Fed officials have acknowledged the U.S. recovery is sputtering, and the threats posed by the Eurozone debt crisis. The Fed has kept the federal funds rate at a record low near zero since December 2008, and has signalled it plans to keep it there until at least late 2014. Under Operation Twist, the third phase of monetary easing following two QEs in 2009 and 2010, the Fed has been gradually selling $400 billion in short-term Treasury securities since September 2011 and using the proceeds to buy longer-term Treasuries. But Operation Twist is set to expire at the end of June. 

A no-change meeting risks disappointing investors and killing the budding rebound in stock prices, which in turn could further dampen U.S. consumer and business confidence. If the Fed does nothing and U.S. stock prices continue to rally, we may actually have something, but it could still be too early, if one subscribes to the Halloween Effect. It is true that this FOMC (Fed Open Market Committee) could present the FOMC with its last opportunity to goose the economy and more specifically financial markets before the end of the year, given that it has historically refrained from taking action too close to elections.

Like the last two summers, stock prices have corrected sharply, taking the markets to short-term oversold levels, allowing for a bounce back to previous resistance levels. As pointed out by Ben Bernanke himself, each successive Fed and other central bank liquidity programs have had an increasingly brief half-life, and it is because of this concern that the Fed may wait to launch further accommodative measures until the market pressure to do so is much higher than it currently is. As  Pimco's El-Erian has written in the FT, the role of central banks has essentially been reduced to the role of fire brigades, i.e., they can reduce the risk of a fire and, should another blaze erupt, stand ready to fight it and contain damage. However, given the complexity of the crisis, they are unable on their own to provide a lasting solution. 

To directly help contain the Euro blaze in Spain, the Fed could provide more USD swap liquidity to the Eurozone. @Soberlook points the the EUREPO curve, which measures how much banks have to pay to borrow, when pledging or repo-ing assets, for loans, as a non-manipulated indicator flashing bright warning signals of a high degree of stress in Eurozone funding markets, which usually means a short-term squeeze on the supply of USD in Euroland.

Source: @Soberlook

Given past seasonality and the timing of additional Fed liquidity measures, we suspect it is still a couple of months too early for the typical bottom of a summer swoon, meaning the recent rebound on Greek elections, expectations for more central bank action is a false start for a more sustainable Halloween effect rally that ostensibly would begin from late calendar Q3, early calendar Q4 2012.