Fed May Need to Boost QE 'Dramatically' This Year: Pros

The Federal Reserve's latest easing move has been nicknamed everything from "QE3" to "QE Infinity" to "QEternal," but some on Wall Street question whether the unprecedented move will be QEnough.


With unemployment remaining high and the effects of previous Fed-sponsored quantitative easingprograms a matter of debate, the central bank is embarking on a round of mortgage-backed securities purchases that will last until the jobless rate comes down to acceptable levels.

From Morgan Stanley chief equity strategist Adam Parker's point of view, the Fed soon will find its new program inadequate.

"QE3 will likely be insufficient to significantly boost equity markets and we wouldn’t be at all surprised to see the Fed dramatically augment this program (i.e., QE4) before year-end," Parker said in a research note.

He said the probability that the Fed will need to juice up the program will increase "particularly if economic and corporate news continue to deteriorate as they have over the past few weeks."

As it stands, the latest round of easing will see the Fed create money that will allow it to buy $40 billion of MBS each month.

Following the conclusion of its September meeting two weeks ago, the Fed said that rather than target a specific amount of purchases — the "quantitative" part of QE — it instead will keep buying until the unemployment rate hits an acceptable though unspecified level.

But Parker said that total will achieve only incremental help in the Fed's quest to spike asset prices, particularly in the stock market, and help out the housing recovery, which it hopes will generate a "wealth effect" that will lead to more hiring.

"Although QE3 is open-ended, the currently announced pace and program of purchases is much smaller than previous QE programs," he said.

Parker estimates based on the previous QE effects that the Standard & Poor's 500 will gain an average of .015 to 0.25 percentage points each week. That won't be enough to offset typical market volatility of 2.3 percent per week, nor will it be enough to spark the economy, he said.

"QE3-related gains could cumulate to 3-4 percent return by year-end, but we see headwinds — negative earnings revisions, especially for 2013, and reappearance of tail risks — that could dominate and more than offset these potential gains," he said.

Parker warns that "size matters" when it comes to QE, but said one thing the Fed got right this time was that MBS purchases, which were the focus of QE1, are more effective than purchases of Treasurys, which were the focus of QE2.

"So far, the announcement of size and composition of QE3 looks like a light version of the QE1 extension," he said.

Parker isn't the only one warning about QE effectiveness.

Capital Economics said there are too many other headwinds in the global economy for the Fed's easing efforts to be a game-changer. Moreover, the firm said pushing down mortgage rates when they already are at all-time lows also probably won't be much help the housing market.

"The Fed can commit to deliver whatever economic outcome it likes, but the problem is that the crisis in the euro-zone and/or a stand-off in negotiations to avert the fiscal cliff in the U.S. may well reveal it to be like the proverbial Emperor with no clothes," Capital economists Paul Ashworth and Paul Dales said.

Stocks have continued to creep higher since the QE announcement, and Parker acknowledged that the Fed's actions probably have accounted for two-thirds of all the market's gains over the past six months.

Bob Janjuah, fixed income strategist at Nomura Securities, advises investors to watch 1,450 on the S&P 500 as a critical level. He forecasts that eventually the Fed money-printing effects will wear off and the index will tumble to the 800 level.

"The important message now is to accept that, in my view, risk assets are in a bubble which of course can extend, but which can reverse sharply and suddenly," he said in a note Monday. "Up here, ‘valuation metrics’ are not going to help much."

Parker advises investors to focus on "growth stocks" — those that have underperformed — with a focus on lower quality. Discretionary sectors and telecom could underperform, while the health care stocks, in particular Stryker , would excel.

He believes the next phase of easing "will be announced by year-end."

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