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Markets Start to Weigh Impact Of Even More Fed Easing

Thursday, 26 May 2011 | 2:29 PM ET

A weakening economy and a wobbly stock market have raised expectations—and in some cases fears—that the Federal Reserve's two-year intervention in the markets may not be over just yet.

Traders work on the floor of the New York Stock Exchange during morning trading.
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Traders work on the floor of the New York Stock Exchange during morning trading.

Just a month ago, Wall Street thought it was ready to say goodbye to the central bank, with many questioning not how long the Fed would stick around but whether it might even head for the exits a bit early.

But with the job market weakening, housing far from recovery and growth stuck at a measly 1.8 percentdespite trillions of dollars in help from the Fed and Congress, Fed Chairman Ben Bernanke's next act suddenly is unclear.

"The opinion of the market has changed quite a bit just in the last month or so—30 days ago very few people would have been expecting a QE3 or QE2 1/2-type situation," Mitchel Schlesinger, managing director at FBB Capital Partners in Bethesda, Md., said, using market vernacular for the Fed's quantitative easing endeavors.

"But the economic data that has come out has been somewhat downbeat since then," he added. "There is growing concern that we have hit a pause in the recovery."

Another round of Fed intervention is expected to have one of two reactions in the stock market—either restoring the rally, as Bernanke's comments in Jackson Hole, Wyo., did back in August 2010, or triggering a loss as it becomes a sign that the Fed believes the economy is still weak and unable to function on its own.

The latter possibility is growing more likely, despite the previous successes of QE at pushing stock rallies.

"The market would probably rally on it at least initially. But some people might view it as a negative that we need a third round because things are really bad. That's how I would view it," says Uri Landesman, head of Platinum Partners hedge fund in New York. "I'm expecting the market to correct. That would be one of the contributors to the correction."

Since the financial crisis hit in 2008, such "soft patches" as Bernanke likes to call them have been cues for the Fed to act. It has done so to the tune of about $2.6 trillion in purchases of various assets, most recently $600 billion in Treasurys that has constituted what is called QE2.

The burning question, then, is whether the latest round of economic softness, reflected both in the data and a 4 percent drop in the stock market, will trigger QE3.

Consensus is that a full-blown stage three of the Fed's aggressive and unprecedented intervention is unlikely.

"Any policy must be judged in terms of the balance between expected benefits, costs and risks," said Mohamed El-Erian, co-CEO of Pacific Investment Management Co, or Pimco, which runs the largest bond fund in the world. "In the case of QE, this balance has shifted away from benefits, and towards more collateral damage and unintended consequences."

In an email to CNBC.com, El-Erian said he believes the presence of higher inflation, global destabilization and the lack of political support in Washington—he cited controversy over "unelected officials with too much ability to make consequential fiscal decisions" as one specific problem—as barriers for QE3.

However, that doesn't mean the Fed can't implement other liquidity measures amounting to what some call either QE2 1/2 or QE Lite.

Such moves would entail the Fed not actually expanding its balance sheet—in essence printing money to pay for the debt it buys—but rather selling existing assets and simply reinvesting the proceeds in other purchases. That would essentially keep the Fed in the game but without raising the red flags that its actions have been incurring.

"Though QE2 is going to be coming to an end soon, the market is anticipating that the Fed will sell the assets on its balance sheet to continue to buy bonds," said Dave Lutz, managing director of trading at Stifel Nicolaus in Baltimore. "It's going to be pretty stunning if something like that doesn't occur."

But strategists are torn over what the Fed's actions or lack thereof will mean specifically to the capital markets.

The main area of agreement, though, is that the uncertainty generated by the end of QE2, coupled with the latest round of worries of European debtand wrangling in Washington over the national debt ceiling, will create a volatile environment.

Markets React to Data and Debt
Discussing the market's weakness, and a look ahead to next month's activity, with Quincy Krosby, Prudential Financial, and Charles Lieberman, Advisors Capital Management.

"Right now taking the riskiest assets out of your mix is appropriate," says Mark Lamkin, CEO and chief investment strategist at Lamkin Wealth Management in Louisville, Ky. "We're in a slow patch and mired in a trading range now."

Lamkin likes intermediate- and long-term municipal bonds as well as high-yield fixed income as the deliberations continue in the central bank and Congress and the European Union ponders bailing out its weak sisters.

Fixed income, indeed, could be continue to be popular as investors hope that the Fed's previous easing efforts have the same result of actually bringing down interest rates.

That's a view predicated, though, on the notion that inflation won't be a problem, which could be problematic should the EU debt mess get completely out of control.

"You've got to be selective where you are," said Kathy Jones, fixed income strategist at San Francisco-based Charles Schwab. "We have relatively sluggish growth, high unemployment and a pretty good-sized output gap. That does not make for an inflationary environment."

With that weak economy, the odds that the Fed does some sort of additional intervention, while far from a certainty, have gone up.

"We learned about Ben Bernanke that at the end of the day he wants to shock the patient back to life," Lutz said. "He thinks he can control inflationary forces. He can't control inflation to deflation. He would prefer our economy to be hot."

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