Global Risk Watch

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CIO WM Research

7 September 2012

Global risk watch
Fed to announce QE3
• We now expect the FOMC to announce a third round of quantitative easing (QE3) at its meeting on September 13. The FOMC is also likely to extend its commitment to hold the Fed Funds rate at an extraordinarily low level. Thomas Berner, CFA, economist, UBS FS thomas.berner@ubs.com Brian Rose, strategist, UBS FS brian.rose@ubs.com Jeremy Zirin, CFA, strategist, UBS FS jeremy.zirin@ubs.com Stephen Freedman, CFA, strategist, UBS FS stephen.freedman@ubs.com Thomas Flury, strategist, UBS AG thomas.flury@ubs.com Giovanni Staunovo, strategist, UBS AG giovanni.staunovo@ubs.com Dirk Effenberger, strategist, UBS AG dirk.effenberger@ubs.com

• Market expectations for QE3 appear fairly high at this point, which could limit the reaction to the FOMC announcement.

• We see a 30% risk of the FOMC deciding not to implement QE3. In this event we would expect most risk assets to sell off. Base case for more Fed action on weak economic growth The jobs report for August was disappointing, with nonfarm payrolls expanding by only 96 thousand. Earnings were flat, and the average number of hours worked ticked lower. The unemployment rate fell to 8.1%, down from 8.3% in July, but it fell for the wrong reason-- a decline in labor force participation. The jobs data appears roughly consistent with our forecast of a 1.5% annualized growth rate in third quarter GDP. For the Fed, that does not represent the "substantial and sustainable improvement" in activity they say is necessary to head off further monetary accommodation. Given Fed Chairman Bernanke's dovish comments in his recent Jackson Hole speech and the disappointing jobs report, we now see a 70% chance that the Federal Open Market Committee (FOMC) will announce a third round of unsterililzed quantitative easing (QE3) at its meeting on September 13. This is likely to consist of Treasury and Mortgage Backed Securities (MBS) purchases. We also expect the FOMC to extend its interest rate forward guidance from "at least through late 2014" to "at least through mid-2015". Market expectations for QE3 appear fairly high at this point, which could limit the market reaction if the FOMC acts in line with our base case. For the equity market in particular, valuations are now significantly higher than when QE1 and QE2 were announced, reducing the potential upside for QE3. However, the dollar could be hurt by QE3, since the market could quickly start worrying about the possibility for QE4 and beyond. In the commodity markets, precious metals have the greatest upside potential as they can act as a replacement for paper money.

Related reports

• US economy: "Fed sets bar low for more
easing", 2 September 2012.

• Global risk watch: "Dimmer prospect for QE3",
20 April 2012.

• Global financial markets: "The Fed shows its
hands", 26 January 2012.

• Global risk watch: "The Fed's next move", 19
December 2011

• Global risk watch: "Let's twist again", 22
September 2011.

• Global Financial Markets: "Will Mad Men take
over the Fed?", 6 September 2011.

This report has been prepared by UBS Financial Services Inc. (UBS FS) and UBS AG. Please see important disclaimers and disclosures that begin on page 7. Past performance is no indication of future performance. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables in this publication.

Global risk watch

Trigger-happy Fed The FOMC minutes showed that even before the disappointing labor report, members were already strongly leaning toward extending the forward guidance (the commitment to hold the Fed Funds rate at an extraordinarily low level) in the last meeting. “Many members expressed support for extending the Committee’s forward guidance, but they agreed to defer a decision on this matter until the September meeting in order to consider such an adjustment in the context of...
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