Fed Easing: What Market Wants vs. What May Happen

Investors with precious little to cheer about these days appear to be hanging their hopes on a last refuge: another round of stimulus from the Federal Reserve that may not come—at least not yet.

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The stock market surged Thursday on the heels of discouraging news that the job growth continued to sputter and that consumer prices actually fell in May.

Both signs indicated that the economywas slowing and teetering on deflation, a condition that the Fed and Chairman Ben Bernanke have long indicated is intolerable.

The developments come at a critical time. The central bank is winding up its Operation Twist program this month—which entailed selling short-dated government debt and buying longer-dated securities—and the market is pondering whether a third round of quantitative easing is on tap.

The market rolled all the signs together and came up with hopes that more stimulus is forthcoming. The Fed meets next week and will issue a policy statement afterwards.

"Let's twist again. It's a Chubby Checker kind of tune that I'm hearing," says John Stoltzfus, chief market strategist at Oppenheimer in New York. "It's not going to be QE3, but it will be putting the flip side of the Twist onto the record player, and that should be good for the market."

Indeed, Wall Street has become hooked on the rollouts of asset purchases that have pushed the Fed balance sheet past $2.8 trillion and, proponents say, goosed the stock market and thwarted previous deflationary threats.

With the U.S. economy slowing and Europe teetering on a euro-zone breakup, there could be little else to explain Thursday's rally except that the market was eager to take another dose of QE, despite longer-term threats of inflation .

"The market likes that kind of support," Stoltzfus says. "Probably longer-term it's not a good thing, that kind of dependency. At least at this point it's a realistic alternative considering the problems in Europe."

There's just one problem with this trading thesis: Fed officials have indicated a strong aversion to more easing once the $400 billion balance sheet-neutral Twist ends this month.

Bernanketold a Senate panel last week that the Fed stood at the ready to intercede, but didn't see an immediate case. That day, in fact, stocks sold off sharply on disappointment, though the market is up about 4 percent since bottoming 10 days ago.

"There wasn't any hint that he was on the precipice of launching QE3," says Michael Pento, an economist and head of Pento Portfolio Strategies in Holmdel, N.J. "The process to QE3 is inevitable, but it's just going to take a bit more time."

Pento sees any of these four conditions needed for more easing:

  • The unemployment rate , currently at 8.2 percent, climbing to 9 percent.
  • The Standard & Poor's 500 dropping another 75 to 125 points or so and getting to the 1,200 to 1,250 range.
  • Gross domestic product growth falling below 1 percent.
  • Inflation dropping below 1 percent.

"I have no doubt that it's coming," he says. "It just has not arrived yet."

"There just isn't anything in the way of debt service relief to come from launching another expansion of Fed buying and monetizing bank assets," Pento adds. "It's just not going to be able to jumpstart the housing market and the economy."

Still, talk of more easing persists.

The most prominent among the QE3-is-coming forecasters is Goldman Sachs chief economist Jan Hatzius.

In an appearance on CNBC's "Squawk on the Street" program, Hatzius predicted that the Fed either will extend Operation Twist or launch another round of easing, probably in the form of buying a combination of Treasurys and mortgage-backed securities.

"If you take everything together there is likely to be easing. I wouldn't say that's a 99 percent call, but I'd say maybe 75 percent, maybe a little more," he said. "The form of easing is complicated because there are a number of things on the table."

Citigroup analyst Brett Rose, though, sees the Fed "at best extending Operation Twist for a short period" with an "inconsequential" effect on interest rates.

Capital Economics experts point out that the Fed only has about $180 billion left of short-dated notes to sell and thus could only Twist for another six months. Like Hatzius, the firm sees a QE3, if enacted, entailing purchases of Treasurys and mortgages, totaling $500 billion.

"Just like QE1 and QE2, however, the resulting boost to equity and commodity prices would probably be short-lived. QE3 may therefore provide a short-term boost to the financial markets, but not much of a long-term boost to the real economy," the firm says.

Alternatively, Capital says the Fed may embark on conditional easing, with asset purchases continuing until the economy hits acceptable growth speed.

Regardless, though, of what the Fed actually does, the market seems to have its mind made up that the central bank, at its meeting next week, will give investors what they want.

"It's a great opportunity for investors who missed stocks in that rally that ran from October of last year to April of this year," Oppenheimer's Stoltzfus says. "So we think it's a good place for stock pickers."

Pento, though, thinks investors may be misreading the Fed's intentions.

"I manage money for a living and I am short the market going into the Fed meeting," he says. "Maybe I'm a fool, but I just don't think the Fed is quite ready."