Will QE2 Become QE2 Lite?

Apparently, rumor has it that the Fed may take a more gradual approach in buying bonds instead of doing it all at once. Rather than drop a trillion dollar bomb like what it did in its first quantitative easing program back in 2009, market participants believe that the Fed will be more cautious in its approach and inject stimuli over the span of six months.

There was also speculation that the scope of QE2 wouldn’t be as large as initially priced in, which forced market participants to adjust to the new information and cover some of their short dollar positions. This led to a three-day winning streak by the dollar, with the euro feeling the brunt of the dollar rally.

How come the Fed is about to chicken out from another round of strong easing moves?

One reason could be that some Fed officials are still overwhelmed by the proposed size of QE2 and are apprehensive about the huge costs and risks in conducting it. They are worried that they might have a difficult time buying up a humongous amount of assets and at the same time expressed concern that these purchases could distort the Treasury market.

Besides, it looks like they are still unconvinced that the benefits of QE2 will outweigh its costs. In other words, they aren’t sure if it’s really worth it. Some are saying that, if the U.S. economy still fails to meet the 2% inflation target even with QE2, the Fed might think of adding to its asset purchases. Now that doesn’t sound too good…

But there are still some Fed officials who believe that QE2 is necessary to spur inflation and boost employment. The unemployment rate is sitting at 9.6%, still dangerously close to double-digit figures, while the annual CPI is still lagging below target at 1.1%.

There is also the issue of weak growth. Just this Friday, the first estimate of the U.S. GDP for the third quarter of this year stood at 2.0%, which was lower than forecast.

Come Wednesday next week, you can bet everyone will be on the edge of their seats to hear what the final verdict will be when the Federal Open Market Committee meets. But just so you don’t get lost in all the commotion, I compiled a short list of things you should pay close attention to in the weeks to come.

1. Size of asset purchases

Who says size doesn’t matter? Almost everyone is already convinced we’ll see a second round of quantitative easing. The only question left on people’s minds is how big it will be. Many think we’ll see a package to the tune of $500 billion, but ultimately, only the FOMC‘s opinion matters.

2. Timing of purchases

Will the Fed go all out and spend everything in one go? Or will we see a more gradual approach over the course of a few months?

3. Fed moves AFTER its initial move

There is a lot of uncertainty surrounding the Fed’s possible moves after its initial announcement as even the Fed seems to be divided over the topic. In the future, will they continue to send signals for further easing or will they ease off the pedal after seeing signs of improvement?

Taken together, these three factors could determine the future for the dollar. On one hand, a lighter version of QE2 could help the dollar rebound as it seems like traders have priced in QE2 with harsh expectations.

But on the other hand, if the Fed’s asset purchase program proves to be larger and extends for a longer period of time than expected, it could cause the dollar to sink once again.

Whatever the case may be, expect the markets to get rocked when the Fed makes its decision next week. Let’s just hope we can roll with the punches.