The market is betting on QE3 - but is that the right bet?

by Wayne Ferbert on August 13th, 2012

According to the staff economists at Bank of America, the market is pricing in an 80% chance of QE3 by the Fed. That is by far the highest predicted percentage I have seen published so far. You can read the column here.

The BofA economists point to not only the rising stock market and rising yields, but even more importantly to the TIPS market. The expectation of higher inflation is showing up in the TIPS pricing. The presumed increase in inflation is expected to be caused by the influx of cheap money from the Fed thru a QE3 program (or thru a major asset purchase program whether you want to call it QE3 or not).

I am a little more suspicious. I think the Fed wants to avoid QE3 at all costs. I think they especially want to avoid it in an election year. But the Fed mandate is bigger than any election so they certainly could take action if the data warrants it. But I believe the Fed is on the fence because of very mixed economic data. For example, despite the poor jobs numbers, earnings season was actually ok. The actual earnings from last quarter were solid. However, forward guidance was not very encouraging. So, I think the Fed will continue to watch the economy much closer before taking this move – including earnings.

QE3 is like a bridge loan. It doesn’t solve your problem. It only works to help you get to the other side. To get to the other side, you have to generate enough earnings to pay for the interest expense and repay the principal. In other words, it is a band aid. It won’t fix the underlying problem. It just pushes the problem off for a bit. Plus, if earnings are solid, then who exactly needs the bridge loan? The Fed will be watching earnings very closely in the coming quarter – but earnings season is still way off.

The disconnect is the improvement in earnings compared to the employment numbers. Hiring has not improved to the level that politicians prefer. So, they want to use QE3 to buoy the economy and markets. I think we have already seen that QE3 only helps with the confidence of the investor community – not so much the corporate executive suite. So, I expect QE3 to help keep the S&P500 around $1400 in the short-term but not create a lot of new jobs.

So, what does all of that mean for the markets? In the short-term, I think it means that the markets will remain ‘buoyed’ by the possibility of a near-term (September??) QE3 event. The economist community carries real weight with investors. However, I think the market has had all of the run that QE3 could generate. The market can only be lifted up so far by the chance of QE3. It looks like the market is running in to resistance.

How would I trade this? I would be selling OTM calls in near months on all of my positions leading up to the potential September announcement. If the market already had its run thanks to the expectation of QE3, then the calls should expire worthless. If the market dips before the announcement, make sure to close the calls early and pocket your profit. At Buy & Hedge, we sell calls to pay for hedges anyway – so sell at will!

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