Talk is starting to build about QE3. Amid increasingly bleak economic data and a rapidly deteriorating situation in Europe, some are pinning their market hopes on a fresh round of Fed stimulus to keep stocks from going down. Despite these pleas, we may not see QE3 coming from the Fed anytime soon if at all. The following are three possible reasons why.
1. QE hasn’t worked so far, so why rush to try it again
Little evidence exists to support the idea that quantitative easing has done much to support a sustainable economic recovery. And some contend it may have done more harm than good. While QE1 was generally (but certainly not universally) accepted as necessary in order to avert a major global financial crisis, QE2 was received with consternation from the start. After the end of QE1 on March 31, 2010, the Fed gave the economy and markets only a few brief months to see if they could stand on their own. But by early July 2010, the Fed decided that trouble was building on the horizon with the potential for the economy to drift back into recession by the fall of 2010. But instead of waiting to see how things actually played out, the Fed opted to intervene well in advance, first by talking up QE2 and eventually executing another $600 billion asset purchase plan extending through June 2011. The Fed was driven to act preemptively at the time by the notion that they were the only available option to help stimulate the economy, as the scope of fiscal policy was limited with increasing public pressure on Washington to cut government spending. However, this abrupt action coupled with QE2’s perceived lack of effectiveness over the past year now has the Fed under intense scrutiny, as many believe the primary result of QE2 was asset and commodity price inflation at the expense of retiree savers living on fixed incomes and low to middle income families.
2. The Fed is now under wilting political pressure
The Fed now has far more at stake this time around when even beginning to think about QE3. It seemed that a driving force behind the Fed’s decision to enact QE2 was the following. As we all know, Fed Chairman Ben Bernanke is an expert on the Great Depression. He is well versed on how cuts in government spending, higher taxes and the tightening of monetary policy in 1936 and 1937 were all likely major forces that resulted in the sharp economic decline back into depression in 1937 and 1938. Given his expertise, he wanted to make sure that today’s Fed under his leadership did not repeat the mistakes of 1936 and 1937, particularly since the mood on the fiscal side was shifting toward cutting spending. So he and the Fed launched QE2.
The sense that this program may have done more harm than good now has the Fed under the political microscope. Many in Congress are now angered by the notion that the Fed may have overstepped its bounds with some of its aggressive monetary actions over the past few years. As a result, the question as to whether the Fed should be able to continue to act independently without some level oversight is now under debate. And another Fed move that might be perceived by politicians as a policy overstep will only intensify the calls for reform.
Any move toward QE3 will likely be taken carefully and deliberately. In the summer of 2010, it seemed that Bernanke did not want to be known as the Fed Chairman who allowed a repeat of the 1937-1938 double-dip. But in the summer of 2011, it is equally likely that Bernanke does not want to be remembered as the Fed Chairman that cost his institution its autonomy and independence from direct Congressional oversight. As a result, it is more than likely that the economy and financial markets will need to be hemorrhaging to the point where the public and those on Capitol Hill are begging him to take action. This implies the potential for much further downside in stocks and the economy before he’s ready to begin discussing QE3. And any such move will likely be in closer consultation with those on Capitol Hill than in the past.
3. The market impact may be far less pronounced the third time around
Like many remedies, the effectiveness fades with each additional application. The same may be true about QE and the stock market. Looking back to early 2009 when quantitative easing was fully engaged by the Fed, a very strong correlation existed between stocks and Fed policy. In short, if the Fed was expanding its balance sheet (QE on), stocks were rising. And if the Fed stopped expanding its balance sheet (QE off), stocks fell. This relationship was fully intact during all of QE1 and for much of QE2. But starting in March 2011, this relationship broke down. And for the last four months of QE2, the Fed’s balance sheet continued to rise by another $300 billion while the stock market languished in a sideways holding pattern. So for the first time, QE was not causing stock prices to float higher.
(Click to enlarge)
Three factors might explain why this disconnect between stocks and the Fed balance sheet occurred. First, markets may have been anticipating the end of QE2 and started to position well in advance of its end. While this may have been true to some extent, such behavior would run contrary to how stocks have demonstrated themselves since the crisis began. We have had a few instances even after the end of QE2 (Greece austerity, European Union rescue) where the global economy looked like it was on the brink of plunging off a cliff, but stock investors remained largely committed to the market until the very last minute and quickly rushed right back in the moment the latest crisis appeared to be passing. In a market that over the past few years has literally acted with knee jerk responses from day to day, it seems unlikely that the primary driver of this relationship breaking down was a market that was anticipating a policy change up to four months in advance.
A second explanation could be the global turmoil that surfaced beginning in March 2011. During the last four months of QE2 we had the Japanese earthquake, the Arab Spring and the latest phase of the European sovereign debt crisis. It is more than understandable why the resulting uncertainty tied to these events would limit further gains in stocks. However, stocks supported by QE had previously shown the ability to completely shrug off these uncertainties and continue to float higher from the beginning until that point. And if stocks were finally showing some sensitivity to global risks at the end of QE2, this does not bode well for stock performance even with QE3 given the turmoil that appears to be building in Europe with Spain and Italy deteriorating by the day.
A third explanation could simply be stock market fatigue. After receiving two successive and nearly continuous rounds of QE over a 2+ year time period, the stock market had more than doubled from its lows and stood at valuations that were far above their long-term historical average (stock market valuations have historically been far below their long-term historical average at this stage during past crises). And all of this occurred in an economic recovery that remained sluggish at best and with a litany of problems dating back to the first days of the financial crisis that remain unresolved. Perhaps the Fed had finally reached the threshold where the market could be lifted no higher without more meaningful fundamental support from the economy behind it. Perhaps the stimulating impact from QE on stocks had finally run out.
Bottom Line
So what does this all imply for markets as it relates to QE3? It may not be coming at all. And if QE3 does come, it may not come anytime soon. Instead, we may need to see a more definitive contraction in economic activity and a severe decline in stocks before the Fed is inclined to act. And even if the Fed does act with QE3, it’s efficacy may not be what stock investors have become accustomed to and are hoping for the next time around. As a result, stock investors pinning their hopes on QE3 may be setting themselves up for disappointment along the way.
The next read on the Fed and their intentions will come on August 9 with the next FOMC meeting. After that, it’s the annual Fed conference in Jackson Hole, Wyoming on August 26. Of course, it was in Jackson Hole last year that the Fed rolled out QE2, so all eyes will be transfixed on Bernanke this year. Given the increasingly struggling economy, these two events will tell us a lot more about whether the Fed plans on bringing QE3 sooner, later or at all. Stay tuned.
Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.
