Julian Harris
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A WORSE than expected outlook for the US economy has prompted the Federal Reserve to extend its stimulus programme known as Operation Twist to the end of the year, although it stopped short of expanding the overall size of bond purchases.

Markets initially sank last night as the Fed revealed that it was not launching further quantitative easing (QE3) despite stubborn unemployment and risks to America’s recovery from the debt crisis in Europe.

“There were a lot of guys out there with the finger on the ‘sell’ button unless they saw balance-sheet expansion (QE3),” said LPL Financial’s John Canally, explaining markets’ sudden drop upon the Fed statement’s release.

Yet investors quickly re-evaluated the situation on closer reading of the statement, and in light of the Fed’s decision to extend Operation‚ÄąTwist.

The Twist, that was due to end this month, will now see the Fed splash $267bn on long-dated securities ­– with maturities ranging from six years to 30 years. To balance out the purchases, it will sell the same amount of Treasury securities with maturities of around three years or less.

“This continuation of the maturity extension programme should put downward pressure on longer-term interest rates and help to make broader financial conditions more accommodative,” the Fed’s statement said.

The yield on 30-year Treasury bonds fell off a cliff as the announcement was made, dropping from 2.77 per cent to as low as 2.68 per cent.

And chairman Ben Bernanke appeared to leave the door open to more QE in his subsequent conference, if conditions do not improve.

“Additional asset purchases would be among the things we’d consider [if required],” Bernanke told reporters. “Our tools can still provide support to the economy”.

Stocks in New York recovered as investors absorbed Bernanke’s statement, and German chancellor Angela Merkel made comments perceived by some to be supportive of rescue measures in the Eurozone – although in later trading shares lost ground again and closed down.

The Dow Jones plummeted by nearly half a per cent on the Fed’s statement; the index later climbed back, and subsequently closed down just 0.1 per cent, or 12.94 points, at 12,824.39.

And trading on currencies was also volatile; the dollar originally jumped on news that more QE did not appear to be in the pipeline, but the euro subsequently clawed its way back to hit a session high last night above $1.274.

“The initial read of the Fed statement was somewhat less dovish than many expected because they didn’t really hint at any additional QE measures,” said Omer Esiner of Commonwealth Foreign Exchange in Washington.

“But on second look, maybe the market is thinking they are flagging some deflationary risks…as well as having left the door wide open to another round of QE if conditions get worse.”

The Fed said it expected unemployment to come down “only slowly” – an even worse verdict than their last forecast of “gradually” lower joblessness.

Unemployment could be as high as 8.4 per cent this year, the Fed said, up from its April forecast of 8.2 per cent.