Stocks, The Fed and QEII

by: Kurt Brouwer

If you are wondering why there is lots of anxiety about the stock market right now, read on. Under Chairman Ben Bernanke, the Federal Reserve has popularized a form of economic stimulus known as quantitative easing (QE). The first round of QE expired a while back and now we are in the last phase of QE II, scheduled to finish up by the end of June.

This report spells out the details [emphasis added]:

Top Fed officials believe the securities purchase program has been effective and has helped improve the economy’s performance in recent months. Some want to see how the economy performs later in the year without it. The recovery, in this view, might be likened to a child riding a bicycle with training wheels. How will it perform when the added support comes off?

What is left unsaid here is that the Fed is deathly afraid of the deleveraging process that is underway in the private sector. Real estate prices are falling. Families and individuals are cutting debt, either by paying it off or going through foreclosure. The only entity actively taking on more debt is the government.

Rebuilding banks on the backs of savers

My belief is that the Federal Reserve is desperately trying to deny reality -- which is that many of our largest financial institutions ran themselves into the ground in 2008 -- so the Fed wants to keep short-term interest rates low. Remember: That is the rate paid on Americans’ savings accounts, money market funds and Treasury bills.

The Fed also wants long-term rates to be fairly high. By keeping short-term rates low and longer terms rates high, the Fed helps banks makes lots of money. Thus, they can rebuild their battered and tattered balance sheets. Unfortunately, that means they are rebuilding their balance sheets on the backs of anyone trying to save money. Thanks, Ben.

QE & the S&P 500

In addition to helping out the banks, the Fed’s so-called quantitative easing policy has also helped the stock market. However, when the first round of quantitative easing ended, the stock market declined. So you can imagine there is some concern about stocks, now that the announced end of QE ll is fast approaching. Check out this chart that shows the recent history of the stock market coupled with significant QE events:

Click to enlargeSource: Calculated Risk
The blue line shows the ups and downs of the S&P 500 from January 2008 to the present time. The red annotations show the timing of significant QE events (if you want to see a bigger version of the chart.
The stock market peaked in May of ’08, then headed south. The bottoming process coincided with the initial announcements (November and December 2008) and later expansion of QE l (March 2009). March 2009 was also the bottom for the S&P 500. When QE l ended on March 31, 2010, the stock market continued its rally, but began falling over the summer. Then, in August 2010, Fed Chairman Bernanke made remarks suggesting that another round of QE would be forthcoming. Stocks rallied and continued rallying after QE ll was announced in November.
The end of QE ll?
With QE ll almost certainly ending on June 30, what’s next for the stock market? Well, I believe it will soften again -- which will lead to calls for QE lll.
Is there a point at which the Fed pulls back and allows the financial markets to sink or swim? Not likely -- at least any time soon.