On Thursday last week, the US Federal Reserve announced QE 3: a program through which it will purchase $40 billion in Mortgage Backed Securities (MBS) every month going forward.

Given the close proximity of this move to the European Central Bank’s (ECB) “unlimited” bond purchasing program announced the week before, the Fed’s move should be taken as a coordinated Central Bank intervention. Thus, we have both the ECB and the Fed going “all in” on their efforts to support the Global Financial System.

This decision will not be without its consequences. Inflationary pressures were already high in the US and around the world. They will be going higher as a direct consequence of the Fed’s move.

Indeed, Oil is back at $100 per barrel. Gold has broken out of its wedge pattern and will likely hit new highs before year-end. And Agricultural Commodities are approaching records due to both severe droughts in the US combined with the Fed and ECB’s announcements.

The Fed has never been good at anticipating the consequences of its actions (see the Arab Spring that resulted from QE 2’s impact on food prices). So we have to ask ourselves, “has the Fed gone too far this time in its efforts to boost stock prices?” 

Our initial view is “yes.” Stocks were already at four-year highs before QE 3 sent them soaring. Our primary concern now is that by announcing QE 3 at this time, the Fed has removed the primary driver of stock prices: the anticipation of more Fed intervention.

Remember, the NY Fed has admitted publicly that without the investor anticipation of Fed action, the S&P 500 would be at 600 today. Thus, by making QE 3 an “open” or “unlimited” program, the Fed has removed this anticipatory effect as going forward investors already know what the Fed will be doing in the future.

Moreover, this open-ended intervention has dramatically raised the bar for any future potential Fed action. Barring a systemic crisis or the collapse of a major bank, the Fed’s hands are now tied due to it having an ongoing intervention in place.

Which leads us to the multi-trillion Dollar question: what if this QE program proves to be a dud? What if the Fed, by announcing such a program, has not only removed the anticipation of future Fed action, but has in fact played its hand too far?

After all, stocks are now extremely overbought and due for a correction. What would a correction do to investor perception of the Fed’s abilities coming so soon after a new large program such as this?

These are the issues to consider going forward. Our view is that it is quite possible the Fed has played its hand too strongly and thereby damaged its future efforts to maintain market stability via intervention. Given that stocks were already decoupled from the underlying economic realities, this has made the market highly vulnerable to a sharp correction.

And then of course, there is the coming inflationary storm to consider.

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Phoenix Capital Research