Is Fed Action and QEII Already Baked Into Asset Prices?

Is Fed Action and QEII Already Baked Into Asset Prices?

Today, stocks were up again – and on low volume, again.  There is speculation that this surprisingly resilient rally is predicated on bets that the Fed will act to protect the economic recovery – or whatever you’d call this thing!

For a look at the wagers being placed on potential Fed action, we turn to guest author Sy Harding, who I believe makes a very strong case that investors may want to consider “buying the rumor, selling the news”…

The Fed’s Big Tease Continues!

October 11, 2010

by Sy Harding, Editor of the Street Smart Report

The Fed is not saying whether it will or won’t.

After its worst August in years the stock market has rallied back strongly in spite of growing indications that the economic recovery has stalled and is now slowing at a disturbing pace. The catalyst has been the market’s expectation that the Federal Reserve will initiate a second round of policy ‘easing’ that will re-stimulate the recovery.

The Fed is not saying whether it will or won’t, alternately holding out the carrot and then withdrawing it, keeping investors and traders uncertain but hopeful.

It was only a few months ago the Fed was talking of the need to withdraw the stimulus efforts of 2008 and 2009. But as economic reports this summer worsened dramatically, the Fed reversed itself, publicly discussing the possible need for another round of ‘quantitative easing’, dubbed QEII.

The market thinks it’s a sure thing, but the Fed continues to issue conflicting signals. Fed Chairman Bernanke will surmise in a speech that the economy is only pausing, and while the Fed will be watchful, action is not needed.

Several Fed governors will then make statements that include assessments that the economy is slowing too fast and action by the Fed is definitely needed.

Then Chairman Bernanke will hint that another round of easing may be needed after all, but several Fed governors will come out and say the Fed needs to wait, that another round of QE will do more harm than good.

Most recently, in a speech in Rhode Island Bernanke said the Fed’s previous program of buying $1.7 trillion of U.S. Treasury bonds and mortgage-backed securities (QEI) was an effective program and “additional purchases have the ability to ease financial conditions.” That was surmised to be the Fed preparing markets for Fed action at its next FOMC meeting in early

However, a few days later, several Fed governors were out with statements that indicate there is considerable debate going on within the Fed about whether another round of easing is necessary, and if so whether it would work this time or not.

For instance Friday morning, even after the dismal employment report, the president of the Fed’s St. Louis district said “This upcoming FOMC meeting is going to be a tough call, because the economy has slowed but it hasn’t slowed so much that it’s an obvious case that we need to do something.”

He added that maybe the thing to do would be to postpone the decision until the Fed’s December meeting, possibly preparing markets for that possibility.

So the Fed’s big tease continues.

Meanwhile, the side of the debate that questions whether another round of easing would be a positive, is getting some traction.

That argument is that QEI in 2008 and 2009 had a positive effect in pulling the economy out of the recession, but the main impact was made by the $700 billion of TARP bailout money, and the home-buyer rebate and ‘cash for clunkers’ programs provided by Congress. QEI contributed
by helping keep mortgage and other interest rates low, but that another round, QEII, by itself would have little or no effect.

It would not create jobs, which is a major problem for the recovery. And QEI already has forced investors to take risks they wouldn’t ordinarily take in an effort to find profits, creating potential bubbles in junk bonds, gold and commodities, and has them even attempting currency trading. Meanwhile, the Fed already piled $1.7 trillion of assets in bonds and mortgage-backed securities onto its balance sheet in QEI, which it will eventually have to sell. Another round of asset purchases by the Fed will only create more risk taking and pump up asset bubbles, without helping the economy or producing jobs, while making the eventual removal of stimulus that much more difficult.

It’s a quite impressive argument, and is apparently not only going on among economists and analysts, but within the Fed.

Another possible reason to expect no action is that the Fed prides itself on being non-political. It therefore hardly ever makes a policy move in advance of an election. While that is more true of presidential elections, this year’s mid-term congressional elections have taken on unusual importance. That may be another reason for the Fed to postpone a decision on QEII until its December meeting, rather than risk being accused of playing politics.

Meanwhile, if the goal of QEII would be to try to inflate the economy out of its rut by pumping up the prices of gold, oil, commodities, and stocks, and holding up the price of bonds, so far the Fed’s ‘big tease’ is working just as well, without the Fed having spent a dime.

Which brings up another question. With Fed action already factored into prices is it going to be a case of ‘buy the rumor, sell the fact’ if action is taken?

Sy Harding is editor of the Street Smart Report, and the free daily market blog,