End of QE2 Setting the Climate for Substantial Downside in Asset Prices

 |  Includes: DIA, QQQ, SPY
by: Cam Hui, CFA

As the markets hold their collective breaths and wait for the FOMC April 27 statement and subsequent Bernanke press conference, it seems that the end of QE2 is baked into the cake. The question is more one of what happens to ZIRP?

I thought I would add my 2 cents worth to the implications of end of QE2. It is evident that one of the purposes of QE2 is to push up the prices of risky assets. John Hussman has complained repeatedly about the effects of this Federal Reserve policy [emphasis added]:

In our view, quantitative easing has been a reckless policy, not only because it has fueled what Dallas Fed president Richard Fisher calls "extraordinary speculative activity," but because aside from a burst of short-term optimism, the historical evidence is clear that fluctuations in stock prices have very little impact on real spending (the so-called wealth effect is on the order of 0.03-0.05% for every 1% change in stock prices). People consume off of perceived permanent income, not off of fluctuations in the prices of volatile assets. Now, it's true that QE2 has probably been good for a fraction of 1% in additional GDP, which should be sustained over a period of a year or two, and though we haven't observed real activity or actual industrial production that matches the optimism of survey-based measures such as the ISM indices, it's clear that some pent-up demand was released. Still, the links between monetary base expansion, stock values, and GDP growth are tenuous at best. The most predictable outcome was commodity hoarding, where our expectations have been fully realized, with awful consequences for the world's poor, not to mention for geopolitical stability.

As regular readers know, I use the Inflation Deflation Timer Model, which depends on commodity prices as the canaries in the coal mine of global growth and asset inflationary expectations, to time the risk-on vs. risk-off trade.

Russ Winter pointed out that there has been a close correlation between the expansion of the Fed balance sheet and commodity prices (click to enlarge image):

With the end of QE2 in sight, Winter asked, "When does the meltup switch into a full-fledged meltdown of the global economy? "

Regardless, John Hussman added that the fate of QE2 is irrelevant as the program is nearly complete anyhow:

The next FOMC meeting is on April 26-27. While there has been some debate on whether the Fed might decide at that meeting to terminate the policy of QE2 early, that debate is actually moot. By the time the Fed meets later this month, QE2 will already be at least 85% complete.

I am already seeing disturbing signs of negative divergence in the stock market. Although commodity prices, which are my principal indicator, haven't keeled over yet, the combination of bearish signals from my secondary indicators and the prospect of the end of the Fed's QE2 purchases are setting the climate for substantial downside in asset prices.