Five potential catalysts for QE3

Despite the recent rally world markets remain in “risk off” mode and are now awaiting the next catalyst.

There are any number of potential negative catalysts out there. Later today for example, the US Department of Labour will release the latest Initial Jobless Claims data, and if the number has ticked up that will be bearish for the market. However it doesn’t necessarily mean that US markets will selloff. It’s actually just as likely that they will rally on anticipation of further stimulus from the Federal Reserve.

This is an important point since markets are no longer responding to fundamentals, i.e. supply and demand, rather they are responding to the stimulus measures enacted by central bankers. A point demonstrated by the chart I showed last month.

When will we get more QE?

The question many market participants are now asking is, when will we see the next round of stimulus from the Fed? Here are five potential scenarios in which I would expect the Fed to announce QE3.

  1. US GDP growth falls to around zero for two or more consecutive months (currently +1.9% in Q1 2012)
  2. The official US unemployment rate climbs back towards 9% (it’s currently 8.2%)
  3. The S&P 500 falls to around 1,100 (it’s currently at 1,314)
  4. The US CPI (Consumer Price Index) falls to around 0.5% or below, i.e. indicating deflation (it’s currently 2.3%)
  5. The US dollar continues to rise to around 88 or 89 on the dollar index. (it’s currently at 82)

A 14 month chart of the S&P 500 Index

A 14 month chart of the US dollar Index

Charts courtesy of Stockcharts.com

The Fed has made it clear that it will take action in order to prevent a sizeable decline in the US stock market, and history tells us that the Fed is equally appose to a strong US dollar.

The bottom line

I believe that QE3 is coming. However we are likely to need to see more pain before it does. When it does come, markets will quickly return to “risk on” mode and will likely rally sharply, at least in nominal terms.

The biggest beneficiary of more QE will likely be gold and gold equities, particularly since they are among the most undervalued assets around.

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