After ECB And G7 Commit To Intervene Markets, Will Bernanke Enact QE3? - Forbes (blog)

Bernanke holds all the cards - Getty Images via @daylife

With G7 leaders announcing they were ready to take coordinated action to ensure financial stability and the European Central Bank buying Spanish and Italian debt, all eyes are on Ben Bernanke as the Fed meets on Tuesday in the context of an FOMC meeting.

Standard & Poor's' downgrade of U.S. sovereign debt pushes markets onto a new phase, where they are forced to reckon with "unknown unknowns," as the only risk-free asset the world has ever known becomes a little riskier, according to UBS' Geoffrey Yu.

With markets going haywire and wealth destruction across the board, the G7 and the ECB have come out in an attempt to calm markets by letting them now that medicine, in the form of coordinated intervention, is on their way.  The G7, which groups finance ministers and central bank governors from the world's biggest economies, was pretty direct, announcing "excess volatility and disorderly movements in exchange rates have adverse implications for economic and financial stability. We will consult closely in regard to actions in exchange markets and will cooperate as appropriate."

The ECB didn't stay far behind, noting that after Spain and Italy passed additional austerity measures, it "will actively implement its Securities Markets Programme [sic]," designed to "help restoring a better transmission of our monetary policy decisions – taking account of dysfunctional market segments – and therefore to ensure price stability in the euro area." (Read Berlusconi Confirms Italy Moving Toward Balanced Budget Amendment).

Government intervention comes as the ace in policymakers' sleeve.  Unexpected by nature, market intervention will surprise many and rock the markets.  Already the ECB has started buying Spanish and Italian debt in secondary markets, according to the FT, which has effectively sent Italian and Spanish yields drastically lower.  From Barclays:

The Spanish-German 10y spread is 95bp lower and the Italian 88bp weaker; in absolute terms the German 10y yield is up 14bp to 2.48%, the French up 6bp to 3.20%, whereas the Italian yield is down 77bp to 5.31% and the Spanish down 87bp to 5.17%

Europe has jumped right into the intervention game, with the Swiss "effectively "announc[ing] QE last week" in order to curb a rising franc in the face of global risk aversion.  The franc has appreciated almost 10% in a month against the U.S. dollar, forcing the hand of a Swiss National Bank that saw its currency appreciate 0.95% to $0.7596 against the dollar in early trading in New York.

With the Japanese consistently intervening markets to quell yen appreciation, all eyes are on Ben Bernanke and Tuesday's FOMC meeting.  As addicted markets beg for more QE, analysts see it as unlikely, both given the political cost and the underlying assumptions (i.e. that the economy is quickly slipping into another recession) of further long-term asset purchases, explains Nomura's FX team. (Read Equity Risk Premium Jumps To Post-Lehman High, Providing Large Cap Opportunity).

The expectation is that the Fed, weary of jumping the gun on QE3, will instead shift the composition of its massive portfolio, keeping size constant.  From Nomura:

A shift in the composition of Fed portfolio while holding size constant is more likely in our view and most likely would entail the Fed rolling principal repayments from MBS etc. back into MBS or into longer-dated UST (rather than those with shorter maturity). This latter would be easily done but not be likely effective.

Other possible actions include "a cut in interest rates on excess reserves" and an "open mouth policy," which means clearer guidance on when the Fed believes those "temporary factors" slowing the economy will ease.  The Fed could "provide some perspective on the nature of the first half slowdown by citing evidence from auto production and sales, labor market indicators and gas prices that the temporary drags on growth are ending," according to Nomura. (Read Goldman Sachs: Recession Is 33% Likely, QE3 Is Coming, GDP Will Grow Only 2%).

While it may seem false at first, Nomura's analysts note that "Many at the Fed believe that markets must be allowed to function with minimal intervention if we are to achieve optimal long-run results," including Chairman Bernanke.  Moral hazard and excessive intervention could cause a steep sell-off in Treasury and Dollar markets, causing further panic.  "The Fed may be well advised not to react in a panic in the current unprecedented situation," despite being forced to keep every option on the table. (Read Debt Deal Cuts To Be Offset By Lagging Growth And Fiscal Risk Premium).

Full Coverage: S&P Downgrades U.S. Credit Rating