Fed's QE3 Is the Drug the Market Craves

BOSTON (TheStreet) -- The Federal Reserve has turned into the ultimate pusher, and quantitative easing is the drug that investors want badly. The question now is whether any good would come of allowing the central bank to continue to enable the markets.

Witness Tuesday's dramatic sell-off following the latest statement on interest rates, which was followed by a dramatic surge into the closing bell and an equally dramatic plunge at the open Wednesday. The Dow Jones Industrial Average, which rocketed higher by more than 250 points in the last half hour of trading Tuesday, gave back that gain and more.

"You have effectively taken those gains away and we are where we traded yesterday before the Fed announcement," says Paul Nolte, director of investment with Dearborn Partners in Chicago. "Should we have rallied 400 points on the Dow? No. We're right back to focusing on debt issues and the unrest in England. Those things below the surface are indicative of a larger problem that we aren't solving."

However, investors still believe in the implicit guarantee, or the so-called "Bernanke put," that the Fed will purchase Treasuries in order to keep prices afloat. In its statement, the central bank said it will leave interest rates low until mid-2013 as economic growth has been "considerably slower" than the Fed expected.

"The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate," the statement from the Federal Open Market Committee reads. "The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability."

Those promises seemed to be the wink and nod that investors had been hoping for. It wasn't an explicit promise, but it was enough to boost equity markets on Tuesday.

"The markets are addicted to that heroin, so to speak," says Lance Roberts, chief strategist at Streettalk Advisors. "The markets know they have that 'Bernanke put' in place. You didn't have a direct statement in terms of 'we're going to start QE3.' Saying that the economy is weaker than they anticipated is a set-up statement for QE3."

The expectation now is that Fed Chairman Ben Bernanke and the central bank will follow the same script as 2010. Last year, equities sold off sharply heading into summer as economic activity weakened. The Fed at first held off from promising more quantitative easing before Bernanke made a speech in Jackson Hole, Wyo., during the Fed's annual symposium. Investors now expect a sequel one year later, with Bernanke set to address the Fed conference Aug. 26.

"The announcement, if we get one, will come around Jackson Hole later this month," Roberts says. "The markets will respond much more favorably if they aren't anticipating it. The Fed left the markets wanting a little more Tuesday afternoon. It's exactly like last year."

The benefit of a third round of quantitative easing is questionable, which may help explain the plunge in equities Wednesday. Roberts notes that the market had a sigh of relief temporarily, but he argues there will be very little impact in terms of the economy. Instead, more quantitative easing will see a smaller impact on the markets.

"In March 2009, everyone was convinced the world was going to end, so QE1 had a very big effect on the financial markets," Roberts says. "The second round of QE gave us some growth in the market but very little economic recovery at all. Each successive round of QE is having a law of diminishing return effect. You're getting less and less effect for every dollar of QE that's used. Eventually, QE will have no effect at all."

Dearborn's Nolte agrees and takes the analogy of quantitative easing as a drug further by noting the painful withdrawals that the market suffers after quantitative easing programs end. "QE1 and QE2 were artificial. When they come off -- ultimately it has to come off -- then you wind up with the pain that we're suffering with now and what we suffered with last year," he says.

Nolte adds that the quantitative-easing measures to date and any future programs will ultimately be ineffective because the Fed is not in a position where it can address the real problems of the economy.

"The QE process has not translated to better economic results because it's not fixing the problem that we have," Nolte says. "The Fed is injecting more into the banking system, not the economy. The overarching issue, both here and in Europe, is debt. The Fed can't do a damn thing about that. It has to come from the political side, and there is no will to address that."

Diane Swonk, chief economist with Mesirow Financial in Chicago, offers her own analogy for the quantitative-easing measures. "You could throw money out of a helicopter, but if it gets stuck in the trees and people can't pick it up, they can't spend it," she says. "It's the private sector that has failed to step up to the plate as government spending has faltered."

"It's back to reality. And reality sucks, but it's exactly what we need," says Michael Pento, senior economist with Euro Pacific Capital. "Bernanke was correct that oil prices and inflation were going to be transitory. But what has proved to also be transitory is economic growth and gains in the stock market."

Pento argues that the U.S. never actually emerged from a recession and that the negative growth was only masked by inflating the consumption bubble.

"You can only juggle that for a limited period of time," he says. "We have an economy that was and still is mired in debt. We have a debt-to-GDP ratio at 92%, double what was in the 1980s. The only thing that happens when you have an overleveraged economy, you need a period of deflation and deleveraging. It's very painful and it causes asset prices and GDP to plummet, but that's part of the healing process to bring things back into balance."

-- Written by Robert Holmes in Boston.