The Federal reserve recently launched a $40 billion a month buyback known as QEIII (quantitative easing). The first and second rounds were launched in the aftermath of the global financial crisis. The Federal Reserve is attempting to ease in an unorthodox manner, since interest rates are already close to zero. Morgan Stanley (NYSE:MS) has just released a bombshell report. They predict that a QEIV (QE4) might be next program launched by the Fed. We covered many of the reasons Morgan Stanley mentions, as to why QEIII would likely be a failure.

Mogan Stanley does not mention a QEV, but as long as there are enough numericals in the Roman Alphabet for it, why not?

Below are some highlights from Morgan Stanley (NYSE:MS):

QE3 will likely be insufficient to significantly boost equity markets and we wouldn’t be at all surprised to see the Fed dramatically augment this program (i.e., QE4) before year-end, particularly if economic and corporate news continue to deteriorate as they have over the past few weeks. While the Fed’s ultimate aim is stable pricing and full employment, key near-term feedback from equity markets could prove disappointing. Why? Although QE3 is open-ended, the currently announced pace and program of purchases is much smaller than previous QE programs. At this pace, we estimate the expected contribution to the S&P 500 from QE3 to be 15-25bp per week. This is much smaller than average weekly market volatility (2.3% since 1980). QE3-related gains could cumulate to 3-4% return by year-end, but we see headwinds – negative earnings revisions, especially for 2013, and reappearance of tail risks – that could dominate and more than offset these potential gains. In addition, there is evidence that gains from QE2 saturated as it continued, i.e., evidence of diminishing returns to the program as some investors speculate.

At this rate of MBS purchase – and based on prior programs – we see only a weekly 25bp expected return for S&P 500 from QE3. While such a return can accumulate over months, it is dwarfed by weekly S&P historical volatility (2.3% since 1980 and 3.0% since November 2008) – and can easily be swamped by macro, earnings and geopolitical events. This is the main reason
we suspect more QE3 (which we will call QE4) will be announced by year-end assuming the EPS trajectory pans out as we suspect.

Another big difference between QE3 and its predecessors is that the former is open-ended (maybe so that we can never call
the next program QE4 officially), whereas the latter had fixed end dates (that were often extended and followed by new QE
programs, of course).

Deutsche Bank also has some comments on QE4 and QEF (forever) in a report issued this morning. They state:

We think yields are gravitating higher and have raised our year-end target for 10s to 2 percent. Fundamental drivers
include a better global growth momentum picture for 2013 as well as our view that the worst of the fiscal cliff is
already priced. QEF (‘F’ for forever) raises some interesting issues in terms of how to frame the outlook for yields if the Fed is
apparently willing to commit to unlimited purchases subject to (economic) conditions. The ability to influence yields
comes down to the play off between depressing real yields directly versus the risk of elevating inflation expectations.
We have a revised nominal yield model for the post crisis period. If the Fed doesn’t deliver on QE4, yields could easily rise towards 2 ½.

We will have more on this breaking topic later in the day.