Rather than doing nothing, the Federal Reserve decided Wednesday to do as little as it possibly could. – Roland Jones

The Path of Least Resistance

The Fed did not adjust interest rates but  reiterated its plan Wednesday to hold down rates until late 2014 to sustain the recovery, and said it will prolong its “Operation Twist” economic stimulus program, adding another $267 billion to a program launched last fall that was due to expire in June, 2010  to sell short-term securities and buy longer-term bonds to push down long-term interest rates. In the plan, the Fed will buy long-term securities (between 6 and 30 years) while selling an equivalent amount with maturities less than three years. This is designed to stimulate the economy by encouraging lending to both businesses and consumers.

Analysts say this represents “the path of least resistance” in a sea of economic troubles, including  a weakening U.S. economy with slowing growth in employment, and a crisis in Europe. The “Operation Twist” program adjusts the composition of the government bonds held by the Fed by swapping short-term assets for longer-term assets. The idea is to push down long-term interest rates, making it easier for businesses and consumers to get credit, supporting the recovery.

J.J. Kinahan, TD Ameritrade’s chief derivatives strategist pointed out that the Greek election, which eased fears of an imminent financial disaster in the eurozone by handing victory to a party that supports Greece staying in the currency union, meant the Fed didn’t have to do anything more radical to boost the economy:

This is the minimum the market would accept. They had to do something, and by extending Operation Twist they’ve given the markets confidence that they are ever watchful,” he said. “They maintained the status quo in a way that the market would be comfortable with. They kept themselves in a position of reacting in case of worse news from Spain or Italy.

Many analysts had expected the Fed to announce something to signal to the markets that it is willing to provide further support to the economy. Operation Twist is likely to have a limited impact on the economy, analysts say.

When reporters asked why the Fed hadn’t done more to stimulate the economy in light of the Fed’s reduction of its growth outlook, Fed Chairman Ben Bernanke said that further quantitative easing “would be something we would consider if we need to take further steps to help the economy.”

Stronger action from the Fed, such as another massive bond-buying program known as “quantitative easing,” (QE), in which the Fed essentially prints money to buy long-term mortgage or Treasury bonds was again resisted.

Holding Its Aces

Critics of QE say that past efforts have had a questionable success rate, and it brings with it the risk of inflation down the road. But a more compelling reason to delay QE is for the Fed to want to keep something in its arsenal in case the economic outlook worsens over the summer.

Earlier this month, Bernanke warned Congress that it must take decisive steps to repair U.S. policies on taxes and government spending, noting that tax increases and government spending cuts that are supposed to start in 2013 — also known as the “fiscal cliff” — could push America into recession if they are not addressed. He said that if Congress fails to act, it will hurt employment in many localities and states and affect the pace of growth in the overall economy, leading to slower economic growth, he added.

He also decided to wait on further European action, including a European Union summit in late June and a meeting of the European Central Bank in early July. If things get really bad, then we may see coordinated central bank action, and the Fed will want to hold in reserve its ability to do as much as possible, consistent with what other central banks are doing:

We are hoping that European policymakers will take the additional steps they need to take to stabilize the situation but we are prepared in case things get worse to protect the U.S. economy and the U.S. financial system.

“The Fed move to extend the Operation Twist program is conservative and wary. The central bank is signaling its concern for the economic future, both American and European, without unduly damaging the present by weakening the dollar,” Worldwide Markets Chief Market Strategist Joseph Trevisani told Reuters.

Banking Doesn’t Welcome the News

The extension of the Operation Twist program has been criticized as having the potential to cause some damage to major financial institutions, especially large consumer banks, since much of the Fed’s operations are directly in mortgage securities, where banks generally borrow money in the short term and lend in the long term. An overall flattening of the interest yield-curve would cut into banks’ margins.

Citigroup (C) is one bank who is poised to take some damage. Its Global Consumer Banking unit brings about half of the company’s total revenue, and represents the bulk of the bank’s growth right now. The segment’s growth was largely fueled by improvements in mortgages. Since some of securities involved in Operation Twist are mortgage-related, Citigroup’s profits in this sector may be hurt from weaker net interest income on long-term loans.

Wells Fargo (WFC) is a major bank that relies on its net interest income, although it appears a bit more guarded than Citigroup with respect to mortgage income. About 50% of its revenue comes from interest differentials on its overall loan portfolio (net interest income). Since its quarterly report, linked-quarter growth was primarily driven by commercial/industrial, auto, and student loans rather than mortgages. This does imply that Wells Fargo would be a bit less susceptible to adverse changes in the mortgage loan market.

Bank of America (BAC), stressed heavily by litigation fees, is also highly susceptible to weakness in the loan markets (with 49% of its total revenue coming from interest income).

BofA’s Consumer Real Estate services unit, despite a $600 million jump in mortgage banking revenue relative to Q1 2011, had a net loss of $1.15 billion in the last quarterly report (Q1 2012) and future improvement needs to be driven by larger net interest incomes, difficult if margins in the mortgage industry decline.

These banks fear that Operation Twist may make it more difficult to grow revenue, even though Operation Twist aims to increase the number of outstanding loans in the financial industry, especially added to their perception that tougher regulations due to the sad state of consumer credit are discouraging this from happening.

The bottom line is that until 2013, the banking industry should feel the effects of twisting, feeling a little sting but their stocks are probably going to be fine in the long run.

Bearing Bad Tidings

In its statement Wednesday, the Fed lowered GDP forecasts (1.9-2.4% from 2.4-2.9%) and expected unemployment to remain above 8% through year-end. This is hardly bullish news despite hints of more action to come if necessary.

Nevertheless, markets want to go higher because, cynically, it’s bonus time for portfolio managers and report card time for clients.

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