What If QE2 Ends On Schedule

QE2, the program that the bi-winning Fed started last November to buy $600 billion of US Treasuries, is scheduled to end in late June. While the market is still priced for a continuing QE2 or a QE3 program, some people are not so certain. Among the doubters, the most influential person is likely Bill Gross, who runs the largest bond fund at PIMCO, as he dumped all the US Treasury portfolio. Recently, he seemed to have gone one step further in shorting US Treasuries as well.

If indeed there's no QE3, and QE2 does come to an end, what will happen? We will not know for sure, of course, until it happens, but it's at least prudent to prepare for it. In the best case, US economy sustains its growth, unemployment improves, inflation is truly tamed (not the way the Fed said, but what main street observes), and interests rate remains low. In that case, stock market will likely rise, and commodities' prices will stabilize. However, even then the voracity of the market's climb is debatable unless unemployment's number improves significantly while commodities' prices retreat.

On the other hand, if Mr. Gross is right, there can be significant downside to many risk assets:

Currencies: US Dollar had become a carry-trade currency since the original QE started, and QE2 only intensified the desire for other high yielding currencies. If interest rates rise, or merely the expectation of rates will rise sooner that it does, look for a sell-off, at least temporarily, on high yielders. Euro is likely the most at risk in this case because of its PIIGS members. Expect USD to rise sharply against Yen as well, as Yen is back again as 'the' carry-trade currency.

Commodities: While the bi-winning Fed took credit of revitalizing the stock market, the denial that QE 2 contributed to the surge in commodity prices is just ridiculous. Unless investors and speculators were prohibited from investing in commodities and must invest only in stocks, the oversupply of liquidity undoubtably contributed or spilled to the commodities market. Therefore, if liquidity is withdrawn, we can expect to see downside in precious metals and other commodities.

Stock Markets: A Strengthened dollar is not welcoming news for companies with strong international sales, and higher interest rates will curtail borrowing for speculation. As investors unwind their USD carry-trades, stock market will most likely suffer. However, there are still various US government stimulus programs at work for this year, which could help to sustain the market in some sectors.

If and when the market accepts that QE2 will end on schedule with no near term follow up of QE3, unwinding of risky assets can begin well before QE2 really end. The end of QE2 will at the very least dampen animal spirits, if not to cause any mayhem in various risk asset markets. Nonetheless, we all know how the Fed wants to be bi-winning, so the prospect of QE3 should never be dismissed, which will help to re-inflate the market again when it happens. When time comes, we will explore what investors should prepare when QE3 hits.

Daniel Ho is the founder of 10xreturn.com, a financial portal providing financial information and market statistics for investment professionals.