Market Preview: Desperate Measures

On the domestic front, Tuesday's rally was in part driven by fresh hope that more stimulus is on the way from the Federal Reserve. And while investors seem to be on board with the idea, Paul Dales, senior U.S. economist at Capital Economics, still doesn't think QE3 is in the cards.

"If hopes of QE3 are to become a reality, either the economy would need to lose a lot more momentum, core inflation would need to fall well below the 2% target, or the downside risks to growth from the crisis in Europe and the looming fiscal cliff at home would need to rise significantly," he wrote on Tuesday.

More likely, according to Dales, is a short extension of Operation Twist, the Fed's current $400 billion Treasury-buying program that involves selling short-term bonds and buying long-term ones. Operation Twist is slated to expire this month and Dales thinks the central bank could opt for an extension at its next policy meeting on June 19-20 but he notes the continuation would be hard pressed to run longer than six months since there are only $180 billion worth of short-term bonds left to sell.

Dales also laid out a scenario of what QE3 might look like if it did come to pass.

"If the Fed did launch QE3, it may buy a mix of mortgage-backed securities and Treasuries, perhaps worth $500bn in total," he said. "And in a new twist it may decide to 'sterilise' its purchases, by conducting reverse repo operations and/or by creating a term deposit facility where banks can park their excess reserves. The rise in the liabilities side of the Fed's balance sheet would then not involve a rise in the monetary base. This would limit the inflationary risk and make QE3 more politically palatable."

As for whether more stimulus would be the panacea the economy needs, Dales doesn't expect the script to vary much from what occurred after QE1 and QE2 -- a boost for the financial markets but a mixed bag for the economy.

"An extension to Operation Twist would probably just help to keep Treasury yields at current levels," he wrote. "QE3 would be more significant as it would probably boost the prices of riskier assets, such as commodities and equities. As long as the so-called wealth effect from the rise in asset prices more than offset any dampening effect from higher commodity prices, then QE3 should boost the real economy."

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