Are the markets already front running a potential announcement of a third round of Quantitative Easing (QE 3)?   Maybe so.  We had expected QE3 at the end of last summer as the economy weakened substantially from the impact of the Japanese earthquake/debt ceiling debate/Eurozone crisis trifecta.  However, with political pressures running high due to the raging battle in Congress raising the debt ceiling there was little support from the public for further intervention.  Furthermore, with inflation, as measured by CPI, already outside of the Fed's comfort zone, the Fed opted to institute "Operation Twist" (O.T.) instead. 

With the Euro-Crisis on the broiler, another debt ceiling debate approaching, the U.S. economy struggling along as Europe slips into a recession and corporate earnings being revised down there are plenty of reasons for stocks to decline in price.  Yet, they have continued to inch up.  With short interest on stocks having plunged in recent weeks it certainly sounds like the markets are betting on something happening and soon.

Let's remember that the goal of both the QE programs and Operation Twist was to suppress interest rates on the longer end of the yield curve in a bet, which has failed to this point, to revive housing.  Those programs did, however, drive a speculative frenzy as money flooded into the financial markets.  As you can see by the chart above the actual implementation of QE1 and QE2 actually kept mortgage rates elevated as money flowed from bonds, suppressing prices and increasing yields, into stocks.   When QE was not in effect and there was no support for the stock market money flowed back into bonds suppressing yields.  The only effective program so far has been the most recent aberration of manipulation which has been dubbed "Operation Twist". 

However, even after more than $2 Trillion of infusions into the system housing is still in the doldrums as it is plagued by problems other than just trying to get interest rates low enough to entice people to buy a home.  The housing market is still flooded with excess inventory and prices that are still higher than long term norms.  The massive shadow inventory of homes that are in delinquent status have yet to be dealt with and the plethora of lawsuits against the major banks for foreclosure fraud and misrepresentation have clogged the progress of dealing with the problems.  Furthermore, high unemployment, excess consumer debt and leverage and tighter lending standards are suppressing individuals ability to qualify for either refinancing or purchases of a home even if interest rates were at zero. 

The importance of the housing market is not lost on the Fed and Ben Bernanke.  Bernanke recently underscored the importance of residential real estate, which represents 15% of the economy, in a study he sent to Congress last week, that said ending the slump is necessary for a broader recovery.  It now appears that the Fed is considering expanding their efforts to try and stimulate the moribund housing market as the study showed that Americans who might refinance and buy properties are getting shut out by stricter lending standards or avoiding transactions as values tumble amid mounting foreclosures.

Here are the stats.  Since the Fed started buying $1.25 trillion of mortgage bonds in January 2009, the value of U.S. housing has fallen 4.1 percent, and is down 32 percent from its 2006 peak, according to the S&P/Case-Shiller index.  Unfortunately, the massive backlog of delinquent properties that need to move through the foreclosure process is likely to suppress prices further.

For "Average Joe" This Is A Losing Game

Currently, it appears as if the market is "front running" a third round of QE coming by March with the current estimate being roughly between another $300 to $750 billion in purchases.   While the markets will likely get some boost from the program it is unlikely to spur any real resurgence in activity in the housing market.  While this might be welcome news for jittery investors clamoring for Fed intervention to help boost market confidence another round of quantitative easing wouldn't be a panacea for the ailing U.S. economy. 

For starters, the global economic landscape is drastically different than it was when the Fed launched its second round of QE2.  Since then, a series of temporary shocks—a catastrophic earthquake in Japan, debt-ceiling drama in Washington, and the sovereign debt crises in the Euro-zone, coupled with more fundamental economic maladies—have rocked the global financial system to its core. Furthermore, the challenges policymakers face differ tremendously as well. Back in 2010, deflation was the crisis of the moment, with markets fearing an unavoidable downward spiral of lower prices, weak demand, and massive lay-offs.

The Fed now faces a much more important problem as it relates to the consumer and ultimately the economy - inflation.  Commodity based inflation has risen markedly during the last two infusions of QE.  With oil prices already in excess of $100 a barrel and food prices on the rise as well the risks to this game are heavily weighted against "Average Joe".  Additional increases in inflationary pressures from a QE program would likely push the economy back into recessionary territory.  In turn this would further impact consumer's incomes, which have been fairly stagnant over the last two years, as they find difficulty making ends meet by combating higher prices.

For an administration that has built itself upon the idea of creating "equality" for all Americans, while pointing the finger at Wall Street and blaming them for their increases in wealth, these programs continue to fuel that divide.   QE programs are great for Wall Street - however, for "Average Joe" it is a drain on their standard of living.

What I Think I Know

While I am not sure that the Fed has the political clearance to fire off another round of QE at this point, given the rise in inflationary pressures and recent ephemeral upticks in the economy, Bill Gross of Pimco apparently does.  According to my friend Tyler Durden at Zero Hedge:  "in December the fund [Pimco] doubled down on its QE3 all in bet, by 'borrowing' even more cash, or a record $78 billion, using the proceeds to buy even more MBS, as well as Treasuries, which hit a combined 31% of the TRF's holdings.  In other words, between MBS and USTs, Pimco holds a whopping 79% of total, mostly in very long duration exposure. In fact, this combination of long duration and pre-QE exposure has not been seen at PIMCO since late 2008, early 2009, meaning that as many banks have been suggesting, Gross is convinced that the Fed will announce if not outright QE3 this January, then at least intimate it is coming."

It appears that the markets are starting to come to the same conclusion given the recent "buy signal" that was issued last week.  While I am not "comfortable" with much of the underlying economic conditions the markets are clearly moving back into a positive trend - at least for now.  However, I wouldn't be "betting the farm" that QE3 will be a decisive win for the economy.