QE 3.5 to come in December?

MarketWatch ran an article citing Fed Watchers believing a QE3 expansion announcement may come in December 2012. Too early too soon? Didn’t the Fed just announced an open ended easing operation a few weeks ago and now we’re speculating about an extension of the easing program? Let us discuss further:

S&P500 Weekly (2008 – 2009)

Back in 2008, Fed’s original QE announcement did not rouse the market. It seems that market wasn’t that impressed with the original $600 Billion amount in Mortgage Backed Securities (MBS) and risk appetite quickly dissipated. It was only after expansion of QE1 was announced did we see a better follow-through upwards.

S&P500 Weekly (2011 – 2012)

For the past 3 weeks, market is reacting to QE3 similar to QE1 – e.g. no proper follow-through in upside. If we were to use QE1 as guide, this is what we will get:

1) Decrease of around 130 points from pre QE announcement – S&P500 back to 1300 level
2) Announcement of expansion made after 4 months – Potential date around 2013 January

Of course, this is pure speculation and some may argue that there is little or no basis to put QE1 and QE3 together. However, one thing is for certain, that is when Fed announce a pure MBS purchase, the market wasn’t convinced. QE2 which has an immediate follow through was focused on procurement of Treasuries, similar to QE1’s expansion which had $300 Billion worth of Treasuries as purchase target. Putting 2 and 2 together, we can come to the conclusion that market does prefer purchase of outright Treasuries as an easing measure rather than MBS.

Admittedly this conclusion is over-simplified, but it is not hard to imagine that should QE3 fail and the above scenario play out, the Fed may announce an expansion of QE3 program to include Treasuries.

So why Jan 2013 rather than Dec 2012?

A few considerations:

1) Analysts general consensus is that impact of QE will only be truly felt after 3 months of implementation.

2) Bernanke may wish to wait a while longer especially with the US Fiscal Cliff decision looming in December

3) December has been a good month for stocks historically. On top of the “Santa Clause Rally”, we have observed the following: S&P 500 showed a positive performance in 70 out of the last 80 years, and we’ve only seen 4 losing months in Dec since 1990.

4) Liquidity is thin in December, any bullish announcements may result in extreme rallies, distorting markets. Eventually market may reverse back to reasonable levels but that would tarnish the feel-good factor of the new policy.

Of course, this discussion will be moot if employment data improves and/or asset prices remain high.

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