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Paulo Santos, Think Finance (377 clicks)
Long/short equity, arbitrage, event-driven, research analyst
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No, I am not talking about a short sale being bought in. As I wrote recently, the environment is such that usually one would get at least a small correction in the market. Between more optimistic sentiment, signs of speculation, the fiscal cliff and some other economic worries such as the recent ISM readings, the most natural course for the market would be to shed some value.

And indeed, mostly due to Apple (AAPL), the market - at least the Nasdaq 100 (QQQ) - did shed some value. But another trouble looms, and this one is a different kind of trouble.

There is a factor emerging which can conceivably force someone to buy. At the very least, it's a factor that speaks against running net short exposure. This factor is, once again, the Federal Reserve. As the FOMC meets next week (December 11-12) the end of operation Twist is coming up. What substitutes it is the wild card that forces our hand.

Operation Twist

Operation Twist is so called because of the way it is supposed to twist the interest curve. It does so by buying longer term securities and selling shorter term notes. So it increases demand and pricing for longer maturities, leading to lower long term rates, while at the same time increasing supply for shorter term maturities where it really has no effect due to the ZIRP lower bound.

Operation Twist is unlike quantitative easing, in that it does not increase the Fed's balance sheet, due to the shorter maturity sales. And this operation was running at a $45 billion pace per month, so even greater than the present QE infinity pace of $40 billion/month.

As Operation Twist ends, the Fed is not going to stand still and allow a material tightening of policy. This means Operation Twist will be substituted. And since the Fed no longer has much in the way of shorter maturities to sell, the substitute won't be another Operation Twist.

And therein lies the rub. Operation Twist is likely to be substituted by yet more quantitative easing. Perhaps not on a 1:1 basis, but still it's likely that we'll see a further expansion of QE.

Quantitative easing

In the best of days, quantitative easing has proved to have a significant positive impact in the market. Indeed, as QE1 and QE2 took place, the market mostly didn't do anything but go up. Not so up to this point with QEinfinity, but then again the amounts were, up to this point, quite a bit smaller than QE1 or QE2.

But what happens if Operation Twist gets substituted? At 2:1, it would add $22.5 billion to the monthly buying pace. At 1:1 it would add $45 billion, more than doubling the current pace and putting QEinfinity in the same league as QE1, QE2 at $85 billion per month. Now, as I said when QE1 and QE2 were active, the market did nothing but go up, so if QEinfinity gets bumped up to the same size, the risk is that the same might happen here. Hence, the chance that this might happen is enough to force one to buy and assume a net long exposure in spite of all the other factors.

Moreover, what would $85 billion per month mean? They'd mean $1.02 trillion per year. Put in other words, they'd mean the US would be printing its entire yearly budget deficit. Such cannot be understated.

Effects

Quantitative easing made through the buying of long-dated treasuries or MBS has a mechanical, positive, effect on the markets. This effect, already explained in the past by me and others such as Pimco's Bill Gross, comes from the fact that the investors selling the assets to the Fed turn around and replace those assets. Most of the time the investors replace them by close substitutes, such as corporate debt, but sometimes the investors allocate a bit of the substitution to riskier assets including high yield bonds, stocks, commodities, you name it.

Since we're talking about a potential $1.02 trillion in purchases, even small percentages of it bleeding off into stocks are enough to push stocks upwards. This was what we observed during QE1 and QE2. The effect on treasury bonds is not so obvious because those are subjected to massive issuance. That is, the yields end up lower than they would otherwise be, but not necessarily lower in absolute terms.

Conclusion

The possible substitution of Operation Twist by more quantitative easing is enough to drive one towards long exposure as a purely defensive maneuver, even if other factors would ask for a temporarily weaker market at this point.

In short, while the Fed is buying with both hands, it's hard to keep a neutral or short position in the markets no matter what the fundamentals are.

Source: On Being Forced To Buy