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Disclaimer: Several reasons I might be wrong are listed under the subtitle "Caveats" near the end.

Author's Note - May 29, 2013: In Dec-2012, a Forbes staff writer wrote a misinforming article entitled "QE4 Is Here: Bernanke Delivers $85B-A-Month Until Unemployment Falls Below 6.5%". Follow-on articles erroneously cited the "6.5%" along with a "2.5% inflation threshold" as being the Fed's triggers to exit QE. However, the Minutes of the Jan-2013 Federal Open Market Committee clearly cite 6.5% and 2.5% as triggers to raise the Federal Funds Rate, and expects said rate not to be raised "for a considerable time after the asset purchase program ends and the economic recovery strengthens". Regarding QE3, the Minutes vaguely report that "...If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of Treasury and agency mortgage-backed securities ... until such improvement is achieved in a context of price stability." Therefore, herein, the so-called "6.5% or 2.5% promise" should be re-interpreted as "an-implicit-promise-not-to-end-QE-before-the-outlook-for-the-labor-market-improves-substantially-in-the-context-of-price-stability." I am indebted to SA member "morphic" for pointing out the error, and regret that a more eloquent correction could not be created.

Theory - There is an immediate path available for the Fed to exit QE with minimal pain, but it requires the Fed to break its "6.5% or 2.5%" promise and is bound to unsettle the stock market even if it's successful. The Fed has three good reasons for exiting QE3 immediately: QE can do no more good, it is actually doing harm, and time is running-out on a window of opportunity created by the Federal budget. ("To exit QE" means to start the gradual reduction of QE down to the appropriate minimum level, which might not be zero, unless banks start lending again, in earnest. See "Avoiding Deflation", below.)

Advice - Over the next month, all investors should consider shifting more weight to risk-free assets, such as U.S. Treasury bonds, as there is a strong possibility the stock market may "stall or fall" in the next three months. What happens thereafter is a coin-toss.

Executive Summary - A multitude of articles in The Wall Street Journal, Seeking Alpha, and elsewhere report that the Federal Reserve (the Fed) is developing an exit strategy for Quantitative Easing 3 (QE3). And almost every author reassuringly says this is good news. Although the stock market has done phenomenally well and there's no shortage of good news and euphoria, every investor should keep in mind a few things:

(1) The original goal of QE was to offset the natural contractions in the money supply due to deleveraging. However, the attempt to stimulate the economy further is a grand experiment, and has not been nearly as successful.

(2) Each month since December 2012, QE3 has injected $85 billion into the economy, and the Treasury has successfully borrowed $70 billion at very low rates. The Fed has promised to continue QE3 until the official unemployment rate falls below 6.5% or inflation rises above 2.5%. (Herein, this is called the "6.5% or 2.5% promise". The word "promise" is used herein for lack of a better term.) The "6.5% or 2.5%" promise has helped stabilize the economy and provide low interest rates for funding the deficit, but can provide nothing more towards a stronger recovery.

(3) The economic recovery has been stymied by the toxic side-effects of QE. See below, "QE's Toxic Side Effects", for details. The toxic side-effects prevent further recovery and promote misallocations of labor and capital and thus make the Fed desirous of exiting QE3 immediately.

(4) Furthermore, in September 2015, a window of opportunity to end QE3 will close, and never reopen. Knowing this, the Fed will be strongly tempted to be aggressive with the unwinding of QE3. See below, "Window of Opportunity", for details.

(5) Once monthly reductions in QE3 are started, there will predictably be fewer dollars bidding for Treasury Bonds at the next Treasury auction than there had been previously. The U.S. Treasury absolutely must fund the deficit and will offer higher-and-higher yields to attract enough buyers. Consequently, the stock market will be forced to compete by offering lower-and-lower prices, unless fewer-and-fewer stockholders wish to sell.

(6) An early wind-down of QE, which breaks the Fed's "6.5% or 2.5%" promise, might be the cause of, or the effect of, an ideological power struggle between Mr. Bernanke and Ms. Yellen. See below, the 2nd-to-last paragraph under subtitle "Caveats". The Fed must immediately choose between (1.) A-stronger-economic-recovery-with-higher-interest-rates, or (2.) never-ending-QE3.

Window of Opportunity - The bipartisan Congressional Budget Office (CBO) released new baseline budget projections in May-2013. According to the CBO's new projections for 2013, 2014 and 2015 (see p. 8 of 18), the deficit is projected to fall from $642 billion, to $560 billion to $378 billion, respectively. But, from 2016 to 2023, the deficit is projected to rise steadily to $895 billion due to entitlements for the growing elderly population. (The baseline budget projections are based on current laws, ignoring possible new laws or future amendments.)

If the CBO projections are credible, the 2013-2015 annual reductions in the deficit translate into easy annual reductions in QE3. The Fed will want to ensure that the economy has sufficiently mended and that QE3 has substantially ended by 2015. Otherwise, we will have one of the following two possibilities:

If the Fed fails to sufficiently mend the economy by 2015, the actual deficits of 2015 and 2014 will be much larger than projected and the window-of-opportunity will be that much smaller. Monthly reductions in QE could prove to be impossible, forcing QE to be continued indefinitely once the deficit starts to swell.

On the other hand, if the Fed has succeeded at mending the economy but failed to end QE3 by 2015, then the Fed will have two unpalatable choices -

(1) weaning the economy off QE3 whilst the U.S. Treasury offers higher and higher yields to attract funds from a slowly dwindling number of buyers for the seemingly-ever-increasing deficit through 2023 and beyond, or more likely, the following:

(2) resigning the economy to an endless program of easy-money which would probably lead into another slump or worse; certainly not a robust recovery, as explained in two subtitles, "QE's Toxic Side-Effects", below.

QE's Toxic Side-Effects, Part 1 - Despite all the excitement and euphoria in the stock market, it's impossible to expect businessmen or investors to have full confidence in the economy and underwrite the normal risks of business-ventures when the mere existence of QE continually raises the obvious question "What will happen when QE3 ends?" This is one of several reasons that QE cannot create more than a modicum of confidence in a QE-based recovery.

QE artificially holds interest rates near zero, and the cost of capital unreasonably low, making practically all business-ventures seem economically viable, whereas many would obviously not be viable when evaluated with a "normal" cost of capital.

Artificially low rates heightens the risk of misallocating capital and labor into projects that should never have been started. These are the projects whose values are most likely to be decimated if ever the cost of capital returns to normal. These are the projects that may be abandoned if they cannot promise an adequate return when the future cost of capital returns to normal.

The original purpose of QE was to avoid deflation and depression (see "Avoiding Deflation", below) and was remarkably successful. The push for greater gains was an experiment that has accomplished little. This is evidenced by the Stock Market and Bond Market reactions every time there is talk of exiting QE, belying the uncertainty surrounding the recovery itself. Investors and businessmen cannot ignore these facts.

QE's Toxic Side-Effects, Part 2 - Because the existence of QE is seen as evidence that the recovery cannot stand on its own, Mr. Producer lacks the confidence to hire, and Mr. Consumer lacks the confidence to spend. Both are logically awaiting the Fed to deliver the 6.5% or 2.5% as in a robust recovery.

However, the Fed is logically counting on Mr. Market to gain the confidence to hire on his own. And the Fed is logically counting on Mr. Consumer to gain the confidence to spend on his own. In other words, the Fed is awaiting Messrs. Market and Consumer to deliver the 6.5% or 2.5%.

The economic recovery is predictably stymied because the Fed has done all it can do, and Messrs. Producer and Consumer will do nothing more because they are well aware of the risks inherent in any recovery supported by QE. And peculiarly with QE3, they have been implicitly promised that the 6.5% or 2.5% will be delivered in the future by the Fed, and in the meantime, there's plenty of QE3 and no worries. So, while they patiently await better business conditions, QE3 has subtly become part of the problem, rather than the solution.

Avoiding Deflation - The first symptom of the 2008 Crisis was the freeze-up in the financial markets, which quickly caused Banks to stop lending. Every loan increases the money supply. And, in reverse, every (partial or whole) loan repayment is a reduction in the money supply. A vibrant lending industry helps keep the money supply growing in a healthy economy by offsetting the natural repayment of old loans with new loans.

Once banks stopped lending in 2008, the economy experienced a predictable deleveraging process as the normal monthly payments of mortgage amortization and debt maturation were no longer offset by the proliferation of loans that the previously vibrant Banking Industry used to make. Deleveraging in the banking system, though natural and predictable, significantly reduced the money supply. (The "shadow banking system", which deals in derivatives, also contributed a lot of deleveraging and reduction in the money supply.)

A contracting money supply makes every remaining dollar more valuable. That's deflation. And deflation can lead to an economic depression in quick order, because no Central Bank has any power to fight deflation, once it takes hold.

Besides natural contractions of the money supply caused by deleveraging, there are other "leaks" out of the money supply:

(1) Foreigners might hold more dollars as "eurodollars"; or

(2) Foreign governments might hold more dollars as a reserve currency for international transactions. Foreign Central Banks might want to hold more dollars as an asset backing up their native currency, though Treasury Bonds are more likely to be chosen for that job.

(3) Savings deposits at 'local' banks might be deposited at one of the 12 regional Fed Banks, earning your local Bank 0.25% per annum.

Each of QE3's newly-printed-dollars enters the money supply immediately upon issue (in exchange for bonds). But the money supply leaks dollars due to deleveraging, eurodollars, reserve currencies, and increased reserves at the 12 regional Federal Reserve Banks.

However, the well-documented growth in the money supply (roughly 6%) and corresponding reduction in the velocity of money suggests that at least some of QE3's newly printed money was not needed simply to offset a 'deleveraging' contraction in the money supply, and the risk of deflation. Unfortunately, it's unclear if the oversupply of QE-printed-money is the cause of the leaks, or if the leaks are causing the over-supply of QE-printed-money. Perhaps each affect the other.

Finally, if the banks don't start lending, the Fed will be forced to continue QE just to prevent contraction in the money supply. This type of QE, perhaps dubbed "QE-min", should be seen as innocuous.

Caveats - There are a number of signs that the economy is recovering but each has its own offsetting caveat:

Good news: The projected 10-year budget deficits have been revised down, however, the original projections were rather steep to begin with, so the revisions are hardly good news. But, admittedly, if such revisions spark hope, optimism or confidence we could be better off soon. The true test of the economy's strength doesn't occur until entitlement spending starts to kick in (in 2015) which brings the projected budget deficit back up-up-up to nearly the level of 2012. Presumably, until 2015, we have the opportunity to both exit QE and mend the economy. Once investors are convinced the recovery can stand on its own, the so-called wealth-effect will be more powerful, perhaps "unleashed" is the appropriate adjective, and the economy might surprise many by "righting-itself" very quickly.

Good news: April-2013's 7.7% Official Unemployment Rate is unexpectedly down from 7.9%. It's also called "U3". But the ranks of the discouraged unemployed, who want to work but couldn't find a job and quit looking, are not included in "U3". And because these people are excluded, the economy's mediocre performance at job-creation is distorted, making it look wonderful.

The Bureau of Labor Statistics adds the discouraged and marginally-attached-to-the-Labor-force to "U3", creating a measure called "U6". In the graph below (unlabeled, my apologies), one can see that "U6" is roughly 13.9% in April 2013 and that "U6" would have to fall to roughly 10.4% for an economy to be labeled "fairly healthy":

Chart is generated for a range of 22 year only

Above, a graph of "U6" from January-2001 to April-2013

Below, the graph of "U3" - the Official Unemployment Rate - indicates that April-2013's "U3" of 7.7% would need to fall to 6.4% for an economy to be labeled "fairly healthy" (which coincides with the Fed's 6.5% threshold to start the exit from QE3):

Chart is generated for a range of 22 year only

Above, a graph of "U3" from January-2001 to April-2013

As the economy recovers, more of the "discouraged" individuals will look for jobs again and swell the "U3" unemployment rate, making it more difficult to reach the 6.5% threshold set by the Fed for exiting QE3. In fact, the recent drop in "U3" was actually credited to roughly 500,000 people becoming "discouraged" in April-2013, causing "U3" to go down while "U6" remained unchanged.

"U3" is misleading. "U6" is the more reasonable measure of unemployment as it shows that a larger percentage of a larger population is desirous of a job.

Good news: 2012's GDP is at an all time high of $15.8 trillion but is subject to (1) later revisions, (2) discounting for inflation, (3) a comparison to "what we could have done" if we had had full employment in 2012 (including the discouraged workers), and (4) questions regarding how much GDP increased simply due to more of the blundering hand of government. (Government does not feel the pain of a poor purchase decision as a taxpayer would. The question about who would be the better spender of deficit money was never even brought to the floor. If a deficit is ordained, then the taxpayer ought to be at least considered as the recipient and spender of some of the monies to be spent, rather than the government in our brave, new world of near 0% interest rates.)

Good news: the stock market is hitting new highs every other day. Literally. Unfortunately, the stock market cannot yet be counted as a "good" sign because QE is propping up the stock market, as recently evidenced by market jitters whenever the Fed talks about exiting QE as in February-2013. The February-2013 release of the Fed's January meeting minutes revealed a mere discussion about exiting QE3, which was something that everyone-should-have-known-was-going-to-happen-sooner-or-later, yet was enough to dip the stock market nearly 2%. It may not sound very significant since the market fully recovered later that day, but why should there have been any such reaction at all? A similar but smaller dip in the market occurred due to the previously mentioned May-2013 article in the Wall Street Journal.

Deficit Projection caveats - Both the Congressional Budget Office (CBO) and the Office of Management and Budget (OMB) projected future budget deficits, but only the CBO projections have been discussed herein. As shown below, the OMB's projected deficits through 2016 are higher than the CBO's because of higher spending estimates. The OMB's projections do not reveal a "window of opportunity" as seen in the CBO's projections. However, the OMB's projections end in 2018, and one can only wonder what they would show if 2019-2023 were included.

The CBO "baseline" projections (2013-2023) assume GDP-growth in a healthy economy, 3.5% per annum. It also assumes that the sequester cuts and the 25% cut to Medicare providers stays in place. Elderly health care entitlement spending drives the CBO projected deficits higher in later years. The CBO's "baseline" budget projections are based on current laws, ignoring possible new laws or future amendments. Unfortunately, assumptions underlying the OMB projections (2013-2018) could not be found.

Note: Revenue, Spending and Deficits are in Billions of dollars:

White House, OMB; Feb 2013RevenueSpendingDeficit
20122,4503,537-1,087
2013 estimate2,7123,685-973
2014 estimate3,0343,778-744
2015 estimate3,3323,908-576
2016 estimate3,5614,090-528
2017 estimate3,7614,247-487
2018 estimate3,9744,449-475
Congr.Budg.Office; May 2013RevenueSpendingDeficit
20122,4503,537-1,087
2013 estimate2,8133,455-642
2014 estimate3,0423,602-560
2015 estimate3,3993,777-378
2016 estimate3,6064,038-432
2017 estimate3,7794,261-482
2018 estimate3,9434,485-542
2019 estimate4,1034,752-649
2020 estimate4,2805,012-732
2021 estimate4,4945,275-781
2022 estimate4,7325,620-888
2023 estimate4,9595,855-896
Differences, (OMB - CBO)D i f f e r e n c e s
2012000
2013 estimate101230331
2014 estimate8176184
2015 estimate67131198
2016 estimate455296
2017 estimate18-145
2018 estimate-31-36-67
2019 estimatenanana
2020 estimatenanana
2021 estimatenanana
2022 estimatenanana
2023 estimatenanana

A "Brick Wall" caveat - The increasing costs of elderly-care (which creates much of the Brick Wall) can be postponed by amendments to ObamaCare and/or Medicare. However, this is not a reliable safety-valve as Congress may not be able to react on a timely basis. And even if Congress is able to react on a timely basis, it could be rightly seen as a temporary measure which would be ignored by the markets, taxpayers and investors.

The Fed leadership caveat - Ms. Janet L. Yellen has apparently been consistently one-step ahead of Mr. Bernanke for years. Hers was the first warning of impending disaster prior to 2007. Hers was the plan to print money. Hers was the "6.5% or 2.5%" exit plan. She's a democrat widely perceived to be Bernanke's heir-apparent, and mostly concerned and focused upon the devastating effects long-term unemployment can have on the livelihood, experience and morale of the labor force, and rightly so. Unions love her. Therefore, she would probably focus on continuing QE and not worry about any mythical brick wall. Bernanke's opinion might differ markedly, as it often has, and he might want to implement QE's unwinding before he leaves Office, especially if he believes the CBO projections correctly predict a window of opportunity to end QE before the "Brick Wall" is reached. And if he gets a good start on unwinding QE, he might assure himself reappointment.

A true recovery caveat - A lot of depositors' money has been deposited in one of the regional Federal Reserve Banks by 'local' banks to earn 0.25%, and is not counted in the money supply. These deposits can be quickly reintroduced to the money supply if and when the depositors feel confident and secure in the recovery. The caveat is that such confidence reduces their so-called preference for liquidity, and increases their preference for spending and/or undertaking investment risks. These deposits could flood back into the economy and wreak havoc, or trickle back into the economy. Both flood and trickle would reduce the need for QE, making the exit from QE easier and quicker, but require the Fed to pay close attention.

Conclusions - Admittedly, it's possible that the Fed has done a better job at staging the recovery than assumed herein. It's possible that as the deficits of 2013 - 2014 become less burdensome, the need for QE diminishes, the exit from QE could proceed without a hitch, and the economy could bounce back with strength from the (herein predicted) "stall or fall of 2013" with an undeniable recovery and prove itself a stunning success by 2015, or earlier.

The Fed wants to break the "6.5% or 2.5% promise" in order to maximize the possibility of having that undeniable recovery in place by 2015. If we are not fully recovered by then, we'll have huge problems with budget deficits that increase every year as entitlements soar. The U.S. National Debt, which might be unmanageable now at $16 trillion, could be utterly unmanageable at $18 trillion in 2015 if the economy isn't humming sweetly.

A lot can happen in the next three years. A globalized economy can turn on a dime, on what seems like a whim, because having so many countries interconnected makes each more vulnerable to unforeseen shocks from some far corner of the world. One small glitch in the eurozone or elsewhere, could cause a domino-like ripple of market failures in the blink of a byte.

Building a higher-and-higher burden of Debt sets us up to be just another domino easily toppled, and once toppled, ever more difficult to fix, you know, like the eurozone. If you have any doubt about that, just ask Mr. Bernanke.

Source: Why The U.S. Stock Market Is Headed Into A Brick Wall