The last week was a nervous time across the financial markets, in large part ahead of quadruple witching, which saw index and equity options and futures all expire on Friday. Volumes were high, and direction was highly uncertain, but finally the close was relatively calm, reflecting low levels of open interest. Investors were hedging heavily earlier in the rebound, and will likely hedge again going forward, but for a period there, the momentum was sufficient to carry ease concerns ? the Vix Index popped back above 30, but traded confidently back below it later in the week.

For all the uncertainty and inaction, it was a down week though. The S&P 500 Index lost -2.6% and oil closed below $70/bbl (although the August contract, which is already the more liquid is still above that level), while the dollar recovered 0.7% against the euro. Emerging markets were even more uncertain. Russia?s RTS Index lost -10.3%, Brazil dropped -4.1% and India fell -4.7%. China?s A-shares index rose 5.0%.

In addition to quadruple witching, uncertainty was also contributed by the lack of activity in treasuries, where most participants awaited with interest this week?s events ? the issuance of $104 bln and the FOMC decision on Wednesday.

The outcome of this FOMC meeting is highly uncertain. Clearly there will be no change in the target rate, and it is quite possible that we will get language that eliminates market expectations of rate hikes this year (click here for our related post). However, the market is more interested in the prospect of further QE. There are arguments both for and against.

The Pro QE Argument

Mortgage costs have increased substantially as a result of the recent treasury yield rally. Cheap retail financing is the primary goal of all this expansionary policy, so many are looking for the FOMC to increase its debt purchase programs to restore accomodation.

The Case Against QE

Yet, it is far from clear that the market is ready for substantially increased Fed spending, and buoyant asset prices suggest that the market is amply benefiting from Fed policy. The problem is not a lack of money in the system, rather how to direct it effectively. With yields pushing back, there is little to suggest that QE has worked so far (although it is of course impossible to know where yields would be without Fed intervention). Buying mortgage bonds serves only to tighten the spread to treasuries, so apparently the Fed needs to buy treasuries to achieve its goal. This it is less eager to do, as means de facto financing the government?s fiscal laxity.

A (temporary) solution might be for the Fed to amend its current program. Currently it has declared plans to buy $300 bln of Treasuries and $1.2 trillion of mortgage bonds, the Fed should eliminate these artificial spending weights, while declaring that absolute spending will remain at $1.5 tln. Such flexibility would help lower real lending costs at the retail level, by tightening the term premium, which is otherwise likely to rise further.

Ultimately, the bond market has not moved much yet, at least not compared to what might happen if the market gets the jitters about a 12-13% GDP budget deficit. It is thus conceivable that the Fed could sit tight for now, but one suspects that it would prefer to (at least try to) keep ahead of the market on Treasuries. It was one thing for the FOMC to keep slashing rates in sync with falling equities earlier in the down-turn, but the bond market is a far bigger beast and the Fed won?t want to play chicken with it like that.

What of the coming week? With the end of 1H09 coming up, it is going to be an interesting one. Here are some of the key data points we are watching for.

Monday

No major economic data expected.

Tuesday

Europe – PMI. Look for moderate improvement, little more.

US ? Existing Home Sales (May). Ignore the bounce, it?s seasonal.

Wednesday

US ? Durable Goods (May), New Home Sales (May), FOMC. New homes will track Tuesday?s Existing Home number. Durable goods are expected to have fallen further, this number could impact the market in the short term, if it surprises either way. The FOMC won?t cut rates, and probably won?t change its money printing program, although it should consider modifying it.

Thursday

US ? GDP (1Q09). This is the last run of the number and it is unlikely to change much from the last estimate (-5.7%).

Friday

US ? Personal Incomes (May), Consumer Sentiment (June). June Sentiment is expected to have recovered moderately, compared to May income data which was down, again.