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The Federal Reserve stopped short of giving the market what it wanted during its June meeting. Rather than give into the baying the market the Fed stood firm and practiced a market-version of the Gina Ford method. Rather than indulge asset markets, it has left them to cope with the Eurozone debt crisis on their own.

No juicy bones from the Fed

They can cry all they want, but the Fed threw the markets the measliest of bones in the form of a $267BN extension of Operation Twist. This doesn't extend the Fed's balance sheet and means there is no more liquidity for the markets to feast on. Thus, as we move towards the summer months there will be no free money to help risk assets to rally.

That doesn't mean that the Fed will leave the market hanging indefinitely. It said that it would act if appropriate. One can imagine that an appropriate time to act would be a Greek exit from the Eurozone or a failed Spanish debt auction. But in the absence of either of these things happening the Fed has restrained from turning on the printing presses just because the market wanted it.

The latest Fed policy action is important for a couple of reasons: 1, the Fed may see the limitations of a third round of quantitative easing. After two attempts the next liquidity injection would have to be bigger and better to elicit a similar reaction in the markets in an attempt to boost business, economic and consumer confidence. Also, the Eurozone debt crisis is essentially doing the Fed's work for them by pushing long-term Treasury yields down to record lows. Right now it looks like lower borrowing rates in the US could be around for a while, and since that isn't helping to boost the economy in a sustainable way, it's hard to see what benefit more QE could have.

Coordinated action: Fed and Merkel?

However, what does have potency for markets at the moment are signs that Germany is softening its stance towards 1, Greece's bailout terms and 2, closer fiscal union. At the same time as the markets announced more QE, Merkel seemed to suggest that bond purchases by the EFSF/ ESM bailout funds could be a possibility. This is a much more meatier bone for risk assets and they loved it. Once the market digested this news it caused EURUSD to make fresh highs of the day and test 1.2730. A decision on sovereign bond purchases is unlikely to come before next week's EU summit, but it gives markets some hope that definitive, concrete action could be taken at the summit. EURUSD may shake off Fed inaction and instead focus on Eurozone political action, which may help the cross to sustain a rally above 1.2750 (a recent double top) towards 1.2825 then 1.29. This is also positive for other risk markets, especially commodities, which have been hit hard by the Eurozone crisis. However, in the short-term we could range trade for a day or so as the markets digest the differing stances of the Eurozone authorities and the Fed.

A novel way the Fed could help the US economy

Now that the Fed's QE seems to have had its day by the Federal Reserve, if the markets get into more trouble then policy makers may have to think up other ways of calming the markets. Right now everyone from Bernanke to Obama is happy to blame Europe for US economic woes. Perhaps the next form QE should take is the Fed buying up Spanish and Italian debt. Europe's peripheral bond markets could do with the Fed's support and if it reduced credit risk it could help provide the conditions for the US economic recovery to flourish. It's a novel idea, but one the US should consider especially if the Eurozone can't solve its problems by itself.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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