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Some would argue that the 6% decline in the S&P 500 from May 1 to June 1 counts as a 'pull back' or a kind of 'semi-correction' that normalizes the market a bit after the relentless run-up from October through April, during which the S&P gained nearly 20%. However, there is certainly a counter-argument to be made that without the hope of additional Fed easing on June 20, stocks would have suffered a much more dramatic decline over the past 8 weeks or so.

The argument that stocks should be lower is compelling given the behavior of the bond market. The appetite for safe-haven securities could not be greater (literally) as U.S. Treasury yields are hovering around all time lows, yields on Swiss debts (5 years and in) are negative, and German bunds are in the midst of a historic rally, with yields on the 10-year hovering around 1.5%.

Adding to the evidence that stocks should be lower is the steady stream of dismal economic data that all but definitively shows the economic recovery is on its last legs. Throughout the European drama and the backsliding economy however, investors have remained hopeful that the Fed will announce new stimulus measures on June 20. These would help reignite the economic recovery and quell fears that policy makers are ill-equipped to handle the fallout from Spain's rather alarming slide towards insolvency. The answer will come today, shortly after two o'clock.

The Fed has indicated (by way of Vice Chair Yellen) that three criteria are relevant to its decision: the outlook for employment, downside risks, and inflation. The employment picture is bleak-- to say the least. May's NFP report was of course a huge miss, printing at just 69,000 on expectations of 150,000, while April's number was revised down to 77,000 and the unemployment rate rose to 8.2%. As for downside risks, the stumbling blocks seem to mount by the day, courtesy of Europe's always late and often inadequate policy responses to the deepening debt crisis. As for inflation, last Thursday's CPI reading further reinforces the notion that there is indeed more room for stimulus:

Consumer prices dropped by the most since the financial crisis in May (.3% decline). When combined with [the] initial claims number which missed expectations printing at 386k vs. 375k estimate, you get a goldilocks scenario for QE3 rumors. Because consumer prices are moderating, the Fed sees the risk of inflation as increasingly minimal, which presumably means they can ease further without fear of a concurrent spike in prices

For its part, Goldman Sachs (NYSE:GS) believes more stimulus is on the way as its chief U.S. economist Jan Hatzius notes that the firm "would be quite surprised if we saw no easing this week," . He adds that "We believe that an extension of Operation Twist could well be insufficient on its own and could thus be followed by additional easing action before long". Hatzius is referring to the Fed's program of selling shorter-dated securities and buying longer-dated notes, as a means of suppressing long-term interest rates. There is only one problem with this:

the Fed will run out of bonds to sell in the sub-3 Year maturity window: after June 30, the Fed will have only $175 million of sub-3 year TSYs in the SOMA, which means an outright extension of Twist under the existing conditions could last at most another 2 months.

The solution of course, is to move the 'detachment' point and sell 4-year bonds as well--the bond market began pricing this in weeks ago.

If the Fed merely extends Operation Twist in the manner just described, expect a sharp pull-back in risk assets (including stocks). This is because for the last two weeks, markets have begun pricing-in an expansion of the Fed's balance sheet via asset purchases (most likely mortgage-backed securities and Treasury bonds). The size of such purchases is likely to be between $400 and $600 billion over the course of 6 to 9 months (again, according to Goldman).

The third possibility is that the Fed will embark on monthly purchases of assets in the amount of $50-$75 billion per month. The reason the central bank could choose this option is that yields can only be held down indefinitely by indefinite purchases of assets. In other words, the downward pressure on yields exerted by programs like Operation Twist abates, or tapers-off, over time, so asset purchases must be perpetual to achieve the desired results.

The problem with Operation Twist (in addition to its diminishing effectiveness discussed above) is that markets have priced-in something more dramatic in terms of easing. The mere announcement that the Fed will now sell 4 year notes in addition to 3 year and in bonds is likely to be quite a letdown, and may very well derail a market where investors' fragile sensibilities are only held together by QE-infused crazy glue. On the other hand, the announcement of a half-trillion dollar asset purchase plan could stoke inflation fears during an election year, a decidedly undesirable outcome (although the Fed is not supposed to care about politics). The incremental (and indefinite) monthly purchase option would both satisfy the market's inflated expectations and provide the added benefit of a low headline number ($65 billion each month sounds better to the general public than $500 billion, even if-- after all is said and done-- the final total is the same).

Some believe the market's expectation of asset purchases is too optimistic. Former Fed board member Robert Heller, for instance, thinks "those who are expecting the Fed to do more than extend Operation Twist are setting themselves up for disappointment". The failure of the Fed to expand its balance sheet on Wednesday shouldn't take investors off-guard, but if the Fed doesn't announce new asset purchases, investors are likely to flee risk assets. I am inclined to take the pessimistic side of the bet: short stocks (NYSEARCA:SPY), long volatility. Even those who are inclined to believe the Fed will expand its balance sheet Wednesday would be wise to pare-back long bets on stocks going into the meeting, or risk bitter disappointment as any post-FOMC hangover is likely to last quite some time.

Source: Stocks To Fall On Possible Extension Of Operation Twist