QE3 May Actually be Harming the Economy: Citi

The Federal Reserve’s third round of quantitative easing is still young, but that hasn’t stopped the major investment firms from analyzing it. The consensus so far is that the program isn’t working as well as might have been expected. Some analysts actually believe the program is the reason for the economy’s poor recovery.

QE3 May Actually be Harming the Economy: Citi

A Morgan Stanley (NYSE:MS) report, entitled QE3-More Is Required, enumerates the most prominent aspects of the latest Federal Reserve program. The report warns that the effects of the program may not be as powerful as some investors assume, but are statistically significant.

According to the investment bank’s analysis, which was performed on a week to week basis, the most prominent attribute of QE3 is that size matters. Morgan Stanley (NYSE:MS) suggests that if the Fed sees the same correlation in its analysis, it is likely to try to widen its program.

Stock market returns were more positive when the Federal Reserve bought more stuff. Purchases of mortgage backed securities, a major part of the QE3 program, were more significantly correlated with positive stock market returns than purchases of treasuries bills.

Interestingly, the analysts found that stock market returns were not correlated with investments made by the Fed in the week before period. This means that the effects of the easing are short term, at least when it comes to stock market returns.

There are also, according to analysis of the Fed’s last program, QE2, diminishing returns associated with the central bank’s intervention. Correlation of stock market returns with Fed purchases declined as the program went on.

The analysis comes to the conclusion that the expected effect of the latest Fed purchases is 25 basis points per week. That figure, as the report points out, falls in line with the average volatility since the advent of the 2008 financial crisis.

As most investors already assume, the report forecasts that the Federal Reserve’s short term lending rate will not increase any time soon. The Federal Reserve’s policy is almost entirely focused on quantitative easing. Rates can’t go any lower, and raising them would be counterproductive.

QE3 May Actually be Harming the Economy: Citi

So what kinds of stocks should an investor look toward in such a climate? According to Morgan Stanley (NYSE:MS), the answer is healthcare. The firm’s analysts are overweight healthcare stocks and technology stocks.

Stocks to avoid, according to the analysis, include those in the discretionary sector and those in the industrial sector. Whether or not that analysis holds up for the entirety of QE3 will depend on many other factors, and the entirety could be an eternity.

As the report points out, QE3, unlike its predecessors, does not have a fixed expiration date. It is open ended. That means there will probably never be a QE4, but the Federal Reserve is likely to tweak QE3 periodically, in order to do what they see fit to the economy.

Citigroup Inc. (NYSE:C) analysts agree that the new round of quantitative easing isn’t working very effectively, but they give at least some distinct reasons for the fallout.

Essentially, according to the Citigroup Inc. (NYSE:C) report, investors seeking steady income are being driven from the bond markets to the equity markets because of globally low interest rates.

Company’s boards are more inclined to give their shareholder’s what they want, higher dividends, than what might be best longer term. If CEOs do not follow this path, according to the report, they may find themselves, under shareholder pressure, replaced by an executive that does.

This means that capital expenditure will not pay off in the short term for executives and global equities, which will be supported by dividend yields and share buyback programs. Firms not investing in capital expansion can expect their profitability to slow in growth.

Separated entirely from the Morgan Stanley (NYSE:MS) report, Citigroup Inc. (NYSE:C) analysts believe that the new round of quantitative easing simply provides investors and firms with the wrong incentives.

The reasoning of the thesis is compelling, and it could be offered as a good explanation for what has been happening in the markets. Perhaps quantitative easing is actually slowing real growth, while providing illusory growth right now.

The Citigroup Inc. (NYSE:C) analysis would explain why the American economy has shown increases in corporate profitability and buoyant equity prices, but less than adequate job creation.

Morgan Stanley and Citigroup both believe that quantitative easing is not working. Morgan Stanley’s analysis, based purely on statistical returns, shows that more will need to be done in order to continue pushing equity prices upward.

Citigroup suggests that it is Federal Reserve policies that are slowing growth in the economy as a whole. The argument will surely be a favorite of those arguing against Fed intervention, but is just one of many jostling theses at this stage.