What Does QE2’s End Means for Various Asset Classes?

This is Part I, where we discuss what occurred; Part II will appear tomorrow morning, analyzing the impact of the end QE.

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Numerous parties have been complaining about — and making erroneous assumptions regarding — the Fed’s policy of quantitative easing. If the liquidity gusher of QE/ZIRP is impacting the primary asset class you are holding — and I am hard pressed to think of one it does not affect — then you best be prepared for what comes when it terminates.

Hence, our deceptively simple question today: What does the end of QE mean to various asset classes?

Its something I have been mulling over for a while. It has been in my mind for the past several weeks as the market has seen risk levels increase and volatility rise.

Recall our prior discussions as to the (actual) reasons we have such an aggressive monetary policy. Here are four primary factors I have concluded are behind the Federal Reserve policy of quantitative easing:

1. To avoid a repeat of the Central Bank errors of insufficient liquidity in the 1930s;

2.To provide the under-capitalized financial sector with a way to rebuild their balance sheets by borrowing cheap (from FRB) and lending dear (to Treasury); Note that a direct injection of capital is not politically feasible.

3. To avoid the painful natural cycle where huge credit booms are followed by painful de-leveraging busts; (the “hair of the dog that bit you” monetary policy)

4. To inflate asset classes in order to restore consumer and investor confidence, thus stimulating consumer spending and investing.

Other than item #1, I find all three of these reasons horribly misguided. And even #1 should only be a temporary liquidity facility, withdrawn as the crisis passes.

The trick as an asset manager is to avoid the easy temptation of the “Wonkery Honey Trap” — avoiding rising asset classes as a protest against terrible Fed policies. Far too many fund managers have succumbed to that foible. The managers who have outperformed over the past 2 years held their noses, then bought into assets sensitive to liquidity.

But with June a mere quarter away, the time to begin contemplating when markets will begin discounting the end of QE2. We might even go so far as to say the Bernanke Put may take a vacation of an undetermined  length.

Let’s consider a scenario where QE2 ends as scheduled in June. What does this mean for the Dollar, Equities, Bonds, Oil, Gold, and Ag-commodities?

It starts with the US dollar. For a little context, note the Dollar Index (DXY) plummeted from over 120 to about 70 — a drop of 41% of its value in just 6 years (2002 to 2008), thanks to the near fatal stewardship by the incompetency twins — Alan Greenspan and George W. Bush.

The financial crisis sent the dollar as a safe haven bank towards 90; since then, it has bounced and slipped back to 75 on a combination of Euro turmoil, hopes for a Japanese recovery, and Middle-East crises. The US bailouts, ZIRP, and QE1 &2 have applied pressure to the greenback during this period.

Bloomberg notes that policy makers are signaling an abrupt end to $600 billion in Treasury purchases, rather than a gradual end to bond market intervention. It is not unreasonable to expect that the end of QE2 will allow the world’s reserve currency to breathe, and perhaps find its footing.  And that is likely to have EXTREMELY serious consequences for Equities, Bonds, Oil Gold and AG commodities.

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Part II, reviewing the impact on various asset classes will be published on Wednesday . . .