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In recent years, deteriorating economic data has led to Fed stimulus in the for of quantitative easing (QE) or operation twist – both efforts to lower borrowing costs for businesses and consumers.
However, a pattern emerged: in the months following a new Fed easing program, markets would rally.
So like Pavlov’s dogs, stock market watchers began to salivate for Fed stimulus in recent months as economic data deteriorated once again.
However, this time the market participants jumped the gun and started bidding up stock prices in anticipation of new policy. And ironically, some believe this rally may have actually encouraged the Fed to hold off on embarking on a new program like QE3.
Meanwhile, economic data has started to show signs of life, slashing the odds of QE even further.
From Goldman Sachs’ Jan Hatzius (via ZeroHedge):
The US economic data continue to look a bit stronger. Tuesday’s retail sales report for July beat expectations, while inventory accumulation showed a further slowdown in June. Our Q3 GDP tracking estimate edged up to 2.3%. The recent news also has implications for Fed policy. While QE3 at the September 12-13 FOMC meeting remains possible, our best estimate is that it will take until late 2012/early 2013 before Fed officials return to balance sheet expansion.
BTIG’s Dan Greenhaus also tackled the issue in his latest memo to clients. He argues that stocks shouldn’t rally on expectations for easing, but rather expectations for an improving economy, which is exactly what’s happening. Similarly, the Fed reacts to economic data, not stocks. From Greenhaus:
More broadly, we’re starting to get questioned as to whether “investors are rallying themselves out of a QE3” and what effect this might have on the Chairman at Jackson Hole. Lets remember something very important; equities should be driven higher by improving fundamentals as well as an improving economic backdrop, not central bank accommodation. Today’s retail sales number, while only one number, serves to boost expectations and with it stock prices. Secondly, rest assured that Ben Bernanke’s medium term economic forecast has very, very little to do with the performance of the S&P 500 over a given one month time frame.