Goodbyes are never easy. But investors seem to reserve a special dread for the imminent end of the second round of U.S. quantitative easing. Without question, QE2 has been a grand success over its brief eight-month life. Investor confidence has soared, propelling equities and commodities sky high.
This is precisely what makes its approaching absence so worrisome. Might financial markets' upward progress halt, or worse, unravel altogether when the program ends in June?
This fear is probably overdone, for five reasons.
First, financial markets are forward-looking. They should already reflect the fact that the stimulus program will soon end.
While we must all concede in the aftermath of the credit crunch that financial markets are hardly perfect in their foresight, the inefficiencies that do exist do not usually extend to pivotal, long-known matters such as the end of quantitative easing. This anticipatory effect plausibly constitutes a reason why markets have already halted their ascent since the end of April and in turn why a further correction once the music has stopped is unlikely.
Second, the main benefit of QE2 - even more so than during the U.S. Federal Reserve's first go-round with quantitative easing - has been through improved confidence, and the restorative effect on financial markets. The Fed has publicly acknowledged this focus. In turn, we can trust that the Fed is doing its best to engineer the removal of stimulus at a time and in a fashion that does not seriously imperil that market progress. If markets melt down despite this, the Fed would have to seriously reconsider the end of the program.
Third, it is tempting - though wrong - to think about quantitative easing exclusively through a "flow" lens - in other words, to dwell on the fact that the Fed is currently buying $90-billion (U.S.) worth of bonds per month, and that this action will abruptly end in a month.
Instead, it is arguably more appropriate to think of quantitative easing through a "level" lens, as the Fed itself does. That is to say, QE2 will have increased the U.S. monetary base by $600-billion and removed an equal amount of government bonds from the market. This stimulus doesn't end in June - it peaks then. Policy will be more stimulative in July than it is today. And the level of stimulus will remain at that peak for the foreseeable future, until the Fed elects to begin selling its bonds.
Fourth, the historical record confirms that monetary-policy inflection points usually have only a modest impact on markets. This is due to forward-looking markets that frequently anticipate monetary policy moves, and the fact that tighter policy is not just a drag on growth, but an endorsement from a credible source that the growth outlook is good enough to warrant a tug on the reins.
The market held together just fine after the end of the first round of quantitative easing in the spring of 2010, only to be felled a month later by Europe's unrelated fiscal train wreck. Providing further confirmation, equity markets usually continue to rise even after the first rate hike in a conventional tightening cycle.
Fifth, the laws of supply and demand are inviolable, and yet they do not dominate the bond market. Many fear that U.S. borrowing rates will spike when the Fed's big buying operation ends. After all, it has purchased the entirety of the net supply of Treasuries over the first half of the year. But demand for U.S. Treasuries is highly elastic, and it takes only a small increase in yield to engender a sizable pop in demand. A back-of-the-envelope calculation suggests that yields will not need to rise by any more than two to four basis points per month to attract demand sufficient to compensate for the Fed's hard stop.
The bottom line is that goodbyes are never easy, but the end of active quantitative easing should not be regarded as a traumatic separation.
The most that can be said is that risk assets have already anticipated the program's demise, and have accordingly edged lower. But even this is a stretch, as the latest downturn is more directly the result of a laundry list of other factors, such as resurgent European fears, negative economic surprises, moderating economic indicators and retreating global growth forecasts.
Going forward, it is these sorts of external drivers that are likely to dominate, to mixed effect. The end of QE2 should not by itself spell death for equities, even as other factors argue for a slower rate of progression in the future. Similarly, it should not alone provide fodder for a spike in bond yields, even as other factors continue to argue for moderately rising yields over time.