Quantitative Easing 2: The End is Nigh!

Ah how fast time flies! It feels like it was just yesterday that markets went ballistic on news about the Fed launching QE2. And now, talks about the END of the extended stimulus program are starting to dominate headlines! So what happens when the Fed finally bids adieu to QE2?

Before we get to the details of the Fed’s farewell to quantitative easing, let’s take a stroll down memory lane back to where it all started.

Late last year, hotshots at the Federal Reserve, or at least most of them, believed that further stimulus was needed to spur the U.S. economy into a more stable recovery and avert the risk of deflation. After all the debates, Federal Reserve Chairman Ben Bernanke gave naysayers the satisfaction of announcing a second round of asset purchases that amounted to 600 billion USD on November 3, 2010.

With only two months left until QE2′s scheduled expiration in June, it seems like Big Ben doesn’t have any regret with the decision.

I know some of you are willing to bet your neighbor’s car that Fed‘s head honcho is wrong but he cites that equity prices have stabilized and are up by 25% in late February since word about further stimulus got out in August 2010. He also said that inflation has picked up and is in normal levels.

Booyeah!

And last but not the least, Bernanke thinks that QE2 has inspired more confidence in investors.

So QE2 worked its magic on the U.S. economy, but here’s the trillion dollar question:

NOW WHAT?!?

Printing money and flooding the markets with Benjamins is the easy part. Heck, just teach me how to operate a money printing machine and I’d be happy to do that for free!

Cleaning up all that extra liquidity is another story though. We can’t expect the easing program to end all by itself nor can the U.S. government simply decide to stop buying bonds. Plus, the government will have to refinance those maturing bonds somehow, unless they plan to hold on to the 2.6 trillion USD worth of assets forever.

There’s also the issue of timing. If the Fed unwinds QE2 too early, who knows whether the U.S. economy will be strong enough to survive without monetary stimulus. Fresh concerns are popping up in the global economy every now and then, and the U.S. seems just as vulnerable as everyone else.

There are a lot of “unknowns” following the end of the Fed’s second round of quantitative easing. Even my trusty crystal ball is cloudy! Nevertheless, I can’t let this piece end without giving my own guesses as to what will happen next!

One of the concerns I have is that demand for Treasury bonds would falter since the Fed won’t be buying anymore. This could lead to a sudden spike in bond yields as investors request for higher compensation on inflation fears. (If you’ve studied our kick-ass School of Pipsology, you’d know that bond prices and yields have an inverse relationship!) Treasury bond investors should be careful.

The end of QE2 could also dampen the overall level of market confidence. There are other issues in the world that have yet to be resolved: Japan is still under the threat of a nuclear meltdown and some euro zone members are still struggling to fix their public finances. At this point, I don’t think the markets can take another Sucker Punch if the Fed acts hastily.