Do Little Fed, Do Nothing Government

Market volatility continued Wednesday, fueled by the Fed’s (not very surprising) announcement it would indeed enact what’s come to be called Operation Twist—selling short-term bonds and buying longer-dated Treasurys, essentially lengthening the Fed portfolio’s average maturity and also likely flattening the yield curve a bit. The Fed also announced it will reinvest interest and principal payments from its mortgage-backed securities (MBS) holdings back into MBS instead of Treasurys. The stated reasoning for the new measures is continued economic sluggishness and a desire to do what it can to maintain low mortgage rates. However, its language on the economy wasn’t new and seemingly didn’t reflect worsening economic conditions.

Flattening the yield curve seems like a dubious goal in an economic environment that isn’t awful but could certainly be stronger. Even the Fed itself considers yield curve steepness among its leading economic indicators. But the Twist likely isn’t a huge negative considering the Fed has short-term rates pegged at 0%, so they likely can’t bring long-term rates down much from their already low level.

We rarely advocate following politicians' lead, but in this instance, we'd have preferred the Fed do nothing at all, which is exactly what our dear elected officials in Congress have (or haven't) been doing—not unusual at this stage with national elections a little over a year away. Signs of another potential budget debate are already emerging—one that could imminently force a government shutdown! Only this time, the debate’s not over raising the debt ceiling (i.e., financing already authorized spending), but over a continuing budget resolution (i.e., authorizing future spending). Congress hasn’t passed a budget this year (yet again—add that to the “do nothing” list), so it’s currently operating on continuing resolutions to authorize spending. The current continuing resolution (to ideally be passed by September 30 when the fiscal year ends) contains provisions to fund FEMA for natural disaster relief.

While the Senate passed a standalone bill funding FEMA for $6.9 billion (to put that in context, it’s less than a drop in the budgetary bucket), the House has included FEMA funding in its version of the continuing resolution . . . to the tune of half the Senate’s approved amount. Senator Harry Reid has suggested if the House doesn’t include the higher level of funding in its bill, the continuing resolution may not pass, forcing a shutdown. Rather a small thing to shut the government down over, but there’s no accounting for what politicians do.

At this point, it seems unlikely the argument isn’t resolved, but stranger things have happened. And given political rhetoric likely flies between now and September 30, there’s always the possibility it drives some added volatility until it’s resolved. But in our view, the more politicians bicker over non-issues, the less market-roiling legislation they can consider. And in that sense, this is an incremental positive. And this desire to “do nothing” likely lasts into and during all of 2012.