The Trillion Dollar Question: What Happens When Quantitative Easing Ends?

One of the great questions being debated right now is how will the market react once QE3 ends this October. Those who believe asset prices (namely stocks, bonds, and real estate) are being supported by the Fed, and not by underlying economic growth, expect a correction or worse once the Fed withdraws its support.

Richard Duncan summed up this view quite well in a recent Financial Sense Newshour interview, Prepare for a Correction Once QE3 Ends:

"[T]his is going to be a very interesting experiment because it will show us whether the economy is actually strong enough to grow by itself without government life support...and, unfortunately, I don't think it is. For an economy to grow one or more of the following three things has to happen: either the workforce has to grow in size, wages have to go up, or credit has to expand. And, right now, none of those things are happening on a large enough scale to drive the economy... So when you remove the one thing that has been stimulating the economy and creating effective demand by pushing up asset prices and creating a wealth effect, when you remove quantitative easing, then where's the new source of growth going to come from? I just don't see it."

Without sufficient credit growth in the economy, Duncan says that we’ll move back toward recession, which will then force the Fed to engage in a fourth round of quantitative easing:

"Once liquidity starts to dry up at the end of this year it looks very likely that the yield on 10-year government bonds will go up. That will cause mortgage rates to go up…the property market to come down, a significant correction in the stock market, a negative wealth effect, less consumption and, I think, then the US will start moving back towards recession. In other words, we'll hit another economic soft patch and before that goes too far I think the Fed will once again have to jump in with another round of quantitative easing, QE4, to follow QE3 and QE2 and QE1. It will be the same pattern."

This pattern of Fed launches QE – economy and stocks go up, Fed withdraws QE – economy and stocks go down is by now very well-known and expected by most market participants. In one sense, we might say it is the most obvious and predictable outcome. Will this pattern play out again or, as the inner contrarian in me always wonders, will the market do what we least expect?

This is where global investment strategist James Kostohryz comes in.

As we discussed in his recent interview, Stocks Likely Moving Into Bubble Phase Over Next Year or Two, what would happen if the economy and stock market fail to see, once again, the long awaited and much anticipated correction, even after QE3 ends?

If that happens—that is, we actually start to see sustainable economic growth and fears of a recession remain at bay—James believes the more likely outcome is that the stock market will enter a bubble as investor confidence really starts to take hold (note: to be fair, he actually makes a number of arguments why a bubble-like scenario in the stock market might unfold).

So, the big question is who’s right? Is the economy strong enough to finally wean itself from QE life-support or will we see the same pattern play out as before?

One of the best ways to answer this question is by comparing the strength of the U.S. economy today to when the Fed ended QE1 in 2010 and QE2 in 2011. Is the economy much stronger or more self-sustaining now than it was during those two prior periods? When we asked Ken Goldstein at the Conference Board this question, this is what he had to say:

“The answer is absolutely…the cycle is starting to move a little bit faster right now and indeed that's what the leading indicators told us would be happening and now it's telling us not only is it going to continue, but it might even start to pick up.”

In addition to the Conference Board, a number of other leading economic indicators have so far all come in positive for the month of July.

Here’s a table showing May, June, and available July data, which Jim Puplava covered in his most recent Big Picture broadcast.

Outside of the last two or three months, what is the direction of the larger economic trend? For that, here’s a chart of the Conference Board’s Leading Economic Index going back to the year 2000 (courtesy of Doug Short), which shows the economy has climbed steadily since 2009 and is not yet in danger of topping out and moving into a recession.

Below the Conference Board LEI is a chart of the S&P 500 over the same time period. Although some believe the market is a poor reflection of the underlying economy (and this may be true over the short-term), over the long-term there is actually a very close correlation, especially when it comes to major turning points.

Looking at the prior two cycles, you can see just how well bull market peaks coincide with a trend reversal in the Conference Board LEI. Typically, you want to start getting concerned about a major market peak once this and other LEIs breakdown.

At this point, however, the overall economic trend is still positive and does appear to be stronger than when the Fed ended QE1 and QE2. The end of QE3 could still cause market disruption, but, one thing is for certain, current and incoming economic data for the U.S. isn't raising any red flags.

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