QE3 Is Priced in the Markets, But Is It Baked in the Cake?

by John Jagerson and Wade Hansen | September 13, 2012 9:39 am

We’ve seen expectations for QE3 being slowly priced into the market for some time, but it now appears the market has gone all-in on its expectations for QE3 today when the FOMC releases its policy statement.

Based on current price levels in the bond market, the stock market and the Forex market, traders are looking for an additional $600 billion in stimulus from the Fed.

So, QE3 has been fully priced into the markets, but is it a foregone conclusion that the Fed will move forward with additional easing simply because the market is signaling it believes it will?

Not necessarily.

You don’t have to look far to see that QE3 is currently priced into the market. There are signs of it everywhere, including:

QE3 Is Priced Into Short-Term Treasuries

Perhaps the best indication that traders have priced QE3 into the market came as the U.S. Treasury auctioned $32 billion in 3-year Treasury Notes. Incredibly, the high yield for the auction came in at 0.337%[1] — the second-lowest level 3-year Treasury Notes have ever brought in at auction.

This number is incredible because it comes at a time when the Fed still is actively engaged in “Operation Twist” — which means the Fed is selling shorter-term Treasuries, like the 3-year, and using the proceeds to buy longer-term Treasuries. This action should be pushing shorter-term Treasury prices lower and yields higher because it is increasing the supply of shorter-term Treasuries on the market.

However, the increasing demand we see for these shorter-term Treasuries seems to be outpacing the rise in supply. This demand jump is evidenced by the bid-to-cover ratio[2] of the 3-year Treasury Note auction, which hit all-time highs at 3.94. This means that for every $1 of new debt the Treasury was looking to raise, traders were willing to buy $3.94 worth of debt. But why the increase in demand?

Traders are looking to front-run the Fed.

If the Fed does decide to move forward with QE3, it’s going to have to start buying more Treasuries and other securities, like agency securities and mortgage-backed securities. Thanks to “Operation Twist,” the Fed is already buying up the lion’s share of longer-term Treasuries, which means it will have to focus on buying shorter-term Treasuries if it wants to increase its balance sheet.

QE3 Is Priced Into U.S. Stocks

SSTchart3091212 300x181 QE3 Is Priced in the Markets, But Is It Baked in the Cake?
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You don’t have to look any further than the daily chart of the S&P 500 to see that QE3 is priced into the U.S. stock market. The S&P 500 is hitting levels it hasn’t seen since May 2008.

The fact that stock prices are surging back toward all-time highs while the global economy is slowing signals just how dependent the stock market has become on the Fed’s easing injections.

QE3 Is Priced Into Gold

GLD 300x181 QE3 Is Priced in the Markets, But Is It Baked in the Cake?
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After a tremendous bull run that lasted for years, gold prices have been consolidating since August 2011[3]. However, as the weekly chart of the SPDR Gold Trust (NYSE:GLD[4]) shows, gold prices just broke out of a yearlong consolidation range that formed a bullish wedge — a bullish continuation pattern.

Renewed interest in gold is based largely on concerns that the more the Fed intervenes in the market by increasing easing, the more likely we are to see inflation and a degradation of purchasing power in the future.

QE3 Is Priced Into the U.S. Dollar

UUP 300x182 QE3 Is Priced in the Markets, But Is It Baked in the Cake?
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The Fed’s monetary actions directly impact the value of the U.S. dollar. The more money the Fed injects into the system, the weaker the U.S. dollar becomes.

It’s simple supply and demand. An increase in supply of the U.S. dollar, especially on the magnitude of QE3, leads to a decrease in the value of the asset. You can see in the daily chart of the U.S. Dollar (NYSE:UUP[5]) that the U.S. dollar’s value has been steadily declining since late July[6] as the market has been preparing for QE3.

QE3 Might Not Be a Lump Sum

One consideration the markets need to keep in mind is QE3 might not be a lump-sum proposition. The Fed might not come out and say it is going to inject $600 billion into the economy during the coming six months.

It could, on the other hand, say it’s going to start a QE3 program, but it will not make any specific dollar amount pledges. This could be disappointing for investors who are looking for clarity and for the Fed to get things jump-started in the U.S. economy.

Bottom line: With the market’s tendency to buy the rumor and sell the news, the fact that U.S. stocks have already moved so high in anticipation of QE3 and the possibility the FOMC might not say exactly what the market wants to hear, we believe there is a good chance we could see a pullback in stock prices in the near term.

John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader[7], a trading service designed to help you make options profits by trading the news.

Endnotes:
  1. came in at 0.337%: http://slingshot-trader.investorplace.com/images/charts/2012/09/SSTchart1091212.png
  2. bid-to-cover ratio: http://slingshot-trader.investorplace.com/images/charts/2012/09/SSTchart2091212.png
  3. gold prices have been consolidating since August 2011: http://www.investorplace.com/2012/08/gld-a-pivotal-moment-in-the-making/
  4. GLD: http://studio-5.financialcontent.com/investplace/quote?Symbol=GLD
  5. UUP: http://studio-5.financialcontent.com/investplace/quote?Symbol=UUP
  6. U.S. dollar’s value has been steadily declining since late July: http://investorplace.com/2012/09/the-global-currency-trade-is-heating-up-fxe/
  7. SlingShot Trader: http://slingshot-trader.investorplace.com/

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