With QE2 Dead, Are We Staring Down a Bull or Bear?

Well folks, the training wheels are off. QE2 is over. Is the economy ready to stand on its own two feet? Will it collapse? Will Uncle Ben and his band of merry bankers rise to the occasion? Let's investigate the scenarios.

First, did the program work? This has two implications. One, if QE2 is thought of as successful, it increases the odds that we'll see a similar version in the form of QE3, should the need arise. Second, as an experimental product, its success would give the Fed another bullet in its arsenal for future economic downturns and crises. As we'll see in a minute, these both have some positive and negative implications for the future economy.

Backing up a bit, QE2 was more properly called Quantitative Easing II, and involved the Fed buying up treasury bills, keeping inflation in check while expanding the money supply. It was a nice work-around for an economy that had nowhere to go with interest rates already at the bottom.

By all measures, QE2 was wildly successful. It provided a shot in the arm to the economy while keeping interest rates low, keeping deflation at bay. The S&P 500 stock index is up 12 percent while The Dow Jones Industrial Average has gone up 11 percent, both big gainers from the announcement of the QE program.

However, these gains have come despite some really negative fundamentals in the economy. Home prices are down and continue to sink. Home sales are not good. Unemployment is 9 percent, and that may be an understated number. Oil prices are driving high gas prices, primarily through speculative actions, and threaten to keep any growth from sustaining itself. There is worry in some quarters that the end of QE2 will essentially remove the training wheels from the economy before it has learned how to ride again.

But not everyone is paranoid of an impeding collapse courtesy of QE2 ending. In fact, a survey of investment managers by CBC showed seven in ten have no concerns about the end of QE2. Only one in ten were worried that the end of easing would derail the economy. Part of that stems from the reality that the end of QE2 isn't really the end of the support. The Fed, by all indications, intends to hold on to its large balance sheet for the time being, providing a winding down period where no new purchases are made, along with no massive sell-offs of treasuries. The interim period could provide some breathing room for the financial world to figure out where the market is taking us all, as well as sort of side issues like oil prices, dollar/gold balances, and unemployment data.

When the Fed finally does start unloading its balance sheet, what happens? It depends on who you ask. Bulls would argue that any gains made in this period will be amplified, as they're the first done without the benefit of QE2 propping up the economy. Think of how excited you got the first time your kid rode a bicycle without training wheels. The market could do just that.

Bears would argue that trying to float an economy right now with a QE backstop is economic suicide, and that we're in for doom and gloom in the future. With no bullets left in the gun for Bernanke to fire, (other than another round of quantitative easing) the government may not have the means to stop the panic a second time. Things could get ugly in a hurry.