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Quantitative Easing Explained

Thoughts on the End of QE 2

Merrill Lynch's Jeffery Rosenburg came out with a fantastic research report on February 16th titled "Double Rainbow". It was an excellent report plus it made me laugh. Unfortunately I can not post it here, but it inspired me to jot some thoughts down of how my best guest of the end of QE2 will play out. Here are those thoughts:

It’s going to get real interesting this summer as QE 2 is schedule to stop. The markets more than ever are being driven by government policy. As a market purist I am not too comfortable with that, but it is what it is. The $100+ billion/mo of “jet fuel” being added to the system through QE 2/POMO is a potent medicine and it has worked thus far. Asset prices are up and company balance sheets are better than they have been in awhile. The wealth effect is beginning to work as “retail” has started the inflows into Equity Mutual Funds. This could carry the market beyond June, but any speed bump (like the Greece crisis after QE 1 or the current middle east turmoil) could scare retail out again. Some research speculate that with the state of the current US deficits it is impossible for the Fed not to start up QE 3. All of these factors can be viewed as positive.

The flip-side is that there is more and more political/international pressure against continuing that policy. The Fed is not getting the desired “good inflation” in housing. Plus the side effects of the medicine are starting to show up in spots that the Fed can’t be too happy with (food, energy, precious metals, etc.). This should have a detrimental effect on an already over levered consumer. Will companies be able to push that commodity inflation on to the consumer without any ill effects? Pricing power has been weak thus far and that has to be concerning to margins. Leverage is still prevalent in the system and deleveraging hasn’t or (better yet) allowed to take its course. I see more cons than pros.

Right now I am bubblish and will hunker down May/June to see how things play out. For fun… my “crystal ball” says that June/July we see the S&P 500 meet a lot of the economist 2011 year end predictions. However by late summer we should see a correction of about 15% and the bearded one institutes QE 3 with an initial market reversal to the positive side. (I don’t think Bernanke will institute QE 3 without a little pain to back him up.) My grand fear is this time it doesn’t work because of the previously outlined bad inflation, margin collapse, higher rates, asset price exhaustion, etc. Plus most of stimulus 2.0 will wear off in 2012 and then we are back to the feared potential tax hikes in 2013. I don’t see what bullets the Fed has to use at that point and we see another bear market with downside of around 30%. 2012 will be a tough year indeed.