As Markets Soar, 'They're Already Talking About QE3'
Now that the Federal Reserve has crossed the Rubicon into its next round of monetary stimulus, the only question for investors Thursday seemed to be what's next.
Markets reacted jubilantly to the Wednesday announcement that the Fed would be adding another $600 billion to its $2.3 trillion balance sheet. Stocks in both US and foreign markets soaredas did commodities, while Treasury prices, particularly in the five- and 10-year notes, also jumped.
The action was all a result of what the Fed calls quantitative easing, a process in which the central bank designates a quantity of assets it will buy which hopefully eases credit conditions through lower rates. The program is known as QE, with the second round called QE2.
So with QE2 out of the way and the market ready to ride the Fed's momentum, talk immediately switched to when the economy will see future QE implementations that some market pros think are little more than an inevitability.
"They're already talking about QE3," said Dave Rovelli, managing director of US equity trading for Canaccord Adams. "Eventually we're going to be printing so much money the dollar is going to really go down and everybody's going to try to deflate their currency against us. I just don't know how this could end well."
For the time being, though, concerns about inflation were out of investors' heads as speculation grew rampant that the Fed has sent an unmistakable signal that it stands at the ready with as much easing as needed to restart the economy.
Unemployment at 9.6 percent and a staggering housing market have mired the economy even as stocks and commodities have soared. The Fed is left to find ways to generate real growth that supports the asset gains.
"It is easy to envisage QE2 giving way to QE3, QE4 and beyond because now that the Fed has started down this road again, it will be very hard to stop unless there are clear signs of improvement in this economy," Paul Ashworth, senior US economist for Capital Economics in Toronto, said in a research note.
The Fed's statement following its meeting this week was noteworthy both for its commitment to continuing its asset purchases, and for reiterating worry that inflation is not at a healthy 2 percent or so level. In addition to the $600 billion in Treasury purchases over the next eight months, the Fed will continue with its monthly Permanent Open Market Operations of $35 billion in mortgage bond spending, bringing the additional total close to $900 billion.
Ashworth speculated that until the Fed reaches its dual mandate of low employment and a manageable growth rate, it would continue buying—expanding its balance sheet to as much as $4 trillion if necessary.
The speculation likely suited Fed Chairman Ben Bernanke and other policy makers, whose impact on capital markets and the economy is judged as much by perception as it is action.
"They have to encourage speculation they will do more if the financial outlook doesn't strengthen, if the economy doesn't show greater signs of self-driven momentum," said Robert DiClemente, chief US economist at Citigroup. "They did say we're going to review this regularly in terms of size and pacing. That was enough to say we could think about this as an initial phase."
The degree of easing likely will depend, then, on the extent to which structural gains in the economy can be achieved.
Should metrics like Friday's nonfarm employment report show accelerated rates of private job growth, and if manufacturing measures keep improving, that could slow the Fed.
But Bernanke faces a dilemma—should the latest round of easing not produce much results, the Fed will have a hard time justifying taking on even more debt even though he has already tipped his hand that he's ready to push for more QE.
"If you get a sustained turnaround in the labor market, they might pass on doing more. That effectiveness question is going to be a monstrous one," said Barry Knapp, head of US equity portfolio strategy at Barclays Capital in New York. "The key issue as we get into the first quarter (of 2011) is going to be effectiveness and whether a likely bounce in business confidence translates into capital spending and hiring."
Barclays has a notably optimistic forecast for 2011—with a projected unemployment rate of 8.5 percent against the current 9.6 percent—predicated largely on an uptick in business sentiment.
"The idea of pushing stock prices higher is to boost business confidence and create a positive wealth effect of consumers to boost consumption, at least for those who are in the investing and savings class," Knapp said. "That's really the game and that's what they're playing for."
Rovelli, of Canaccord Adams, thinks investors should "ride the gravy train, but use tight stops. When your stocks rally, you take a little off the table. Sell at least half your position and keep half to ride it higher."
For the typical investor that can be a dangerous game to play.
But for now, it's hard to argue with success, even if there are inflationary consequences at the end of those gravy train tracks.
"The judgment is they need to do whatever they can do, recognizing that it may fall short. Doing nothing is not an option," DiClemente said. "What they have accomplished in these two years since we have gotten to zero interest rates has produced measurable improvements in financial conditions."