When the Federal Reserve undertook quantitative easing back in November, 2010, it began a program for the second round of the Fed's commitment to buy $600 billion in US Treasury bonds to keep interest rates low and spur economic growth. The program had a designated endpoint of June of this year, which investors again know is on the horizon.
What Happens When QE 2 Ends?
So what happens when QE 2 ends? This is what investors want to know. First, what about the reaction to QE 2 itself? Free market critics have said QE 2 has skewed the markets, kept interest rates artificially low by flooding the economy with more easy money gushing into the system , which has buoyed both equity and bond prices. They maintain that when the faucet is turned off and the money flow dries up, interest rates will skyrocket and the stock and bond markets will both face a precipitous drop. The economy, which was also supposed to be helped by QE 2, is still sluggish, with a stubbornly high unemployment rate.
Advocates—or at least those who even grudgingly acknowledge the need for QE 2—maintain that because of the inadequacy and the early inaction of the Fed as the subprime mortgage crisis unfolded, with near-failures of mega banks Citigroup (NYSE: C) and the actual collapse of Lehman Brothers, that QE 2 was necessary. Yes, there was a QE 1, which was much more limited in scope, and in the odd logic of the era of too-big-to-fail along with everything else from Bernie Madoff to Bear Stearns to the near collapse of the US auto industry (just to mention a few lowlights of the financial crisis), we not only needed to bail out the banks, apparently more bailing, into the whole economy, was necessary. The bottom line of this approach or realization was that even with QE 1, the Fed thought more was needed.
QE 2, TARP, QE 1, Too Big To Fail And More
Despite the often highly-politicized reactions to QE 2, despite the railing against it by free marketers and the necessities invoked by its advocates, however reluctant, QE 2 happened. So, we'll never know whether the economy, markets, or Citigroup would have failed, because in the lineage of TARP, and QE 1, though its stock did brush under the magically low $1 per share figure, Citi, for example, was saved.
An Ugly Chart
As its chart below shows, despite the sleight-of-hand reverse split for its share price recently, which renders its once $1 share price as a $10 share price (no, we don't make this stuff up), Citigroup produced as ugly looking a chart as its management did results, or lack of them. Citigroup was indeed the stock market poster child for the financial crisis. So read QE 2 as born of the TARP and QE 1 family, simply another spawn.
This assumes that QE 2 will actually cease after June, though that is not certain. Perhaps the program will be extended or perhaps there will be another program created following it. QE 3? It's possible the Fed might do this, though unlikely. At some point, so the argument goes, the economy has to get weaned off of these juicy programs and stand on its own.
The conventional wisdom is that a multiplicity of things will happen: stock prices will fall, as will bond prices, while bond yields of course will rise inversely. The end of the commodity run also would be a strong possibility.
Let's quickly look at these potential outcomes. Both stocks and bonds depend to some degree on the money supply. This makes sense, as capital in the system, that money which is beyond the need for other needs is what gets invested in the equity and debt markets. Also, the commodity run has featured speculative excesses already, with oil, silver, along with other metals, even to some extent, gold. Agricultural raw materials such as corn and wheat have seen their prices boosted by commodity speculation on top of their normal cyclical robust run. Most observers agree that the end of QE 2, when the Fed stops buying $75 billion in Treasurys each month, will end the upward momentum of these markets. The artificially low interest rates and increased money supply will be over.
Annual Growth of Money Supply Chart from John Williams' Shadow Government Statistics
What Should Investors Do?
Investors should always be vigilant and watch their holdings, of course. Should QE 2 end as predicted, while it's possible the markets will see a major correction quickly, more likely a slower pullback will take place. After all, it's not as if professional investors and money managers will be (or at least they shouldn't be) surprised at the cessation of easy money. While some see a doomsday scenario, it's unlikely. The markets may retreat—the air may be taken out-- the economy will be forced to get along without the extra support, and in time, gradually, investors may find opportunities again. Smart investors will stay ready.
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