Dear member,

On Wednesday, June 20th the Federal Reserve announced the extension of its 'Operation Twist' program through the end of 2012. The news came as little surprise and the program will likely be extended further before the next deadline. This game of 'will we or won't we' is getting old. If the Fed stops buying, interest rates rise and the economy implodes. Extending 'Operation Twist' involves the Fed selling its medium or short-term bonds, which have reached maturity, and buying longer-term bonds to the tune of $267 billion. Instead of shrinking its ballooning balance sheet, the Fed doubles down on long-term debt (keeping the market liquid with artificial demand) and stands ready to print money as the open market warrants.

The economics of a central bank purchasing its own country's bonds is far from practical and will create uncontrollable inflation at some point. The Fed has created a market where the buyer of long-term bonds and seller of short-term bonds is one in the same. This is manipulation at its finest and is being conducted on a grand scale. Throughout the course of history there are dozens of examples where this activity has ultimately led to inflation or even hyperinflation. In the short-term, it creates artificial demand for US dollars and US debt. It creates liquidity. By keeping interest rates low, America continues to be viewed as a safe haven and has no issues making interest payments on its debt. These low rates keep mortgage rates low as we all sit and pray for the economy to do something - anything other than threaten to collapse entirely.

The Reaction to the Fed Announcement

The markets scoffed at the $267 billion extension of 'Operation Twist' and sold off mildly on Wednesday. Thursday saw the real response as investors woke up from the bailout hypnosis, realising that nothing major was coming from the Fed in the immediate future. Horrible earnings, along with even worse forecasts, were reported by many of America's largest companies. This data revealed the bearish sentiment and continued slowdown of the US economy. From Europe to China, slower global economic growth was predicted last week, which also put pressure on US stocks and commodities. Every asset except short ETF's or government bonds took the plunge Thursday as a free-fall across the board took place. To put the recent selloff in perspective, the CRB commodities index lost more than 2 percent on Thursday alone, its biggest single day decline this year (that's saying a lot considering the volatile year we've had thus far). The CRB Index is now almost at its lowest level since September 2010.

The Fed might be making its way back to the podium before too long.

Bernanke made several interesting comments during his Wednesday address, but there is one in particular that we'd like to highlight:

"Business fixed investment has continued to advance. Household spending appears to be rising at a somewhat slower pace than earlier in the year. Despite some signs of improvement, the housing sector remains depressed. Inflation has declined, mainly reflecting lower prices of crude oil and gasoline, and longer-term inflation expectations have remained stable."

The Federal Reserve does not even include crude oil and energy in its CPI or core inflation targets, yet when the price of crude collapses, it uses this to justify low inflation?! What's so interesting about the above comment by the Fed is that it has begun using energy prices to its advantage, depending, of course, on which direction they happen to be moving. Oil has been falling and dipped below $80 a barrel Thursday, and yes, that will help the consumer, but has nothing to do with the CPI. The CPI is the main gauge, constantly referenced and used by the Fed, to determine interest rates and implement monetary policy.

Despite record cash injections over the past few years, the CPI has remained low. This is because consumer wealth has been destroyed in the housing and stock markets - the two greatest generators of wealth for the middle class.

The Federal Reserve recently reported that the median net worth of families plunged by 39% in just three years (from $126,400 in 2007 to $77,300 in 2010). Two decades of growth and subsequent wealth generation has been erased. This 39% loss puts Americans' average net worth roughly on par with where it was in 1992!

Back to the CPI Index. When you include the 39% net worth loss and add-in the rising food prices and energy costs (over the last 20 years) to the calculation, there is no money left to drive up prices for the goods and services the CPI takes into consideration. Remember that food and energy are not included in the CPI. Despite the Fed expanding the money supply, there is no money left in households (because of the loss in average net worth) to push the CPI higher. The creates a false sense of deflation.

The Fed also said that it expects to keep rates at "exceptionally low levels" at "least through late 2014". No surprise there. Could you imagine if the Fed increased interest rates? The markets would capitulate and implode with just a 50 basis point move up.

The Fed is running out of options here and Obama might as well concede defeat if Bernanke, Congress or the private sector doesn't turn this economy, and the stock market, around quick. Without going through a ton of short-term pain, which would involve entering a 2-5 year depression amidst massive de-leveraging, there are few options to turn this economy around.

A massive monetary stimulus package, engineered to flood the markets with liquidity, would help the economy (albeit short-term). If large enough, this just might buy Obama enough time to win this coming election. However, getting any kind of stimulus package passed in an election year is next to impossible. Another saviour for the economy would be a revival in hiring from the private sector, which at the moment has its hands tied up in new regulation across many different industries. Don't expect anything significant in the near-term from the private sector. So it really comes down to the Fed. Will Bernanke act in such a way to make the market optimistic again? Extending 'Operation Twist' wasn't enough.

Bernanke has been singing from the high heavens about low inflation for months on end. He wants the world to believe that another round of QE wouldn't drive inflation to dangerous levels. If it were just up to him, we believe another round of QE would have been announced this past week. It is still early and the Fed has the opportunity to act, but Bernanke may have held back recently, from another round of quantitative easing, due to a few defectors from within the Fed ranks.

Dallas Federal Reserve Bank President, Richard Fisher, has been questioning calls for the Fed to inject additional monetary stimulus into the U.S. economy as early as June 2012. He has argued that it will not address the problems caused by the turmoil in Europe, or slower growth in emerging economies.

The Fed risks creating a divide within its own ranks, as well as giving Republicans firepower, if it acts too soon on an additional round of QE. With that said, when the economy goes to hell in a hand basket, there will be no resistance for further easing. What will Mr. Fisher say when the economy begins contracting or the reported unemployment rate begins knocking on the 10% door once again? What happens when the US bumps up against its debt ceiling in a few months? Or when there is no money or subsidies left to take care of the elderly or unemployed? The pressure will be applied from all angles and the Fed will step up to 'rescue' the economy. In the meantime, there is little positive news within the US economy to focus on.

A Quick Note on Commodities

The commodities supercycle and bull-market is not over. Commodities and commodity based assets (mining stocks, oil & gas stocks etc.) will benefit from a devalued USD. The USD will resume its free-fall in due time. At some point, like all commodity bull markets of the past, it will end. However, this commodity-bull still has a number of years left.

Walking a Tightrope

The US has to be very careful. If confidence in America's ability to pay its debt begins to wane, things can turn very quickly. It wasn't too long ago; Greece had record low interest rates and was basking in the sun of Euro Zone membership, auctioning off its debt at low yields to ample global buyers. If the US economy continues to capitulate and begins to fail, tax revenues will diminish and Obama's promises will become emptier than usual. He's only been able to follow through in recent years by running annual $1 trillion plus deficits. If the economy does not expand sooner rather than later, the only way to maintain any subsidies will be to dilute the USD, by printing a lot of money to pay for unfunded liabilities and maintain interest payments (and solvency).

The Fed's extension of 'Operation Twist' on Wednesday has brought to light some other tough decisions that must be addressed soon. The Bush Tax Cuts (click here to watch Bill Clinton interview on extending Bush Tax Cuts) are set to expire at the beginning of 2013, along with reductions in federal spending and the aforementioned scheduled conclusion of 'Operation Twist'.

If economic data continues to turn negative, and the stock market continues to fall, the Fed will be quick to act.

We know we sound like a broken record, but if you think Bernanke isn't watching the S&P and Dow Jones like a hawk, think again.

All the best with your investments,

Pinnacle Digest