Some investors fear June swoon after QE2 ends

/ Source: The Associated Press

Could the financial markets be heading for a June swoon?

The answer likely hinges on what happens after the Federal Reserve's $600 billion effort to boost the economy expires. Some investors warn that the end of the program, known as QE2, will upend the stock market and push other markets in unexpected directions.

Under QE2, the Fed buys Treasurys from investors who can then put the money in stocks and other investments. Economists call it quantitative easing, and it is the second time the Fed has used the tactic.

Since last August, when Fed Chairman Ben Bernanke outlined the plan, the Standard & Poor's 500 index has gained 26 percent. Many also say it's partly to blame for rising commodity prices on everything from silver to cotton.

"It's the most important factor that explains markets the way they are now," says David Rolley, co-head of global fixed income at the fund manager Loomis Sayles. "So the most important question is what happens when QE2 stops?"

Ask investors and you get a variety of opinions. Bill Gross, manager of the world's largest mutual fund at Pimco, fears the worst. Take away the largest buyer of Treasurys and, he says, their prices are likely to fall and long-term interest rates likely to rise. That could hurt the economic recovery, and it's one reason his fund has dropped nearly all of its Treasury debt.

Other investors and economists, including those at Goldman Sachs, believe QE2 will expire without a stir. A top Fed official agrees.

"I wouldn't expect to see a financial market reaction to the termination of that program," said Janet Yellen, vice chair of the Fed's Board of Governors, in a speech in New York. She said that investors have already priced in the end of QE2.

Skeptics point to last April when a Fed program to buy mortgage bonds ended. A report by David Rosenberg, chief economist at Gluskin Sheff, outlined what happened between April 23 and August 27:

  • The Standard & Poor's 500 index lost 153 points, or 13 percent.
  • The yield on the 10-year Treasury sank from 3.84 percent to 2.66 percent, as fears over a double-dip recession sent investors into safer investments.
  • Gold rose from $1,140 an ounce to $1,235.

"Sure, there's the possibility that the economy can stand on its own two feet now," Rosenberg says. "But we haven't seen that happen yet."

Another risk? Many investors believe the Fed will extend QE2, despite signs the economy is strengthening. Thirty percent of the 70 economists and money managers surveyed by CNBC in March expect the Fed to keep buying. Failure to do so could sour investors on the stock market.

Many investors have become addicted to the Fed's help, says Robert Arnott, chairman of Research Affiliates, a money management firm.

"Most expect it to be over but secretly hope it won't," he says. "There's a whole lot of wishful thinking out there."

Complicating everything is the debate over raising the federal borrowing limit. Treasury Secretary Timothy Geithner recently said the government may hit the $14.25 trillion debt ceiling as soon as May 16. If Congress fails to raise the limit, the government will lose the ability to sell new bonds to pay off debts coming due. In the worst-case scenario, the government could default, leading to a financial crisis.

"All hell breaks lose," Arnott says. To be sure, the economy is more stable than last year. Unemployment has dropped from 9.8 percent to 8.8 percent in four months. Consumer spending has increased for eight months. Fed officials have turned their attention to rising food and fuel prices.

Many see the end of Fed support as a badge of good health. "We have to take the training wheels off at some point," says Richard Skaggs, equity strategist at Loomis Sayles. He dismisses Rosenberg's argument that stocks could fall and bonds could rise in a repeat performance of 2010.

"The past doesn't really repeat itself," Skaggs says.

Earlier this year, Skaggs was worried that the Fed's bond-buying was causing stocks to rise too quickly, setting the stage for a fall in June. But stocks dropped in March in response to the earthquake in Japan's earthquake, rising oil prices and other world events.

Now Skaggs believes markets rest on more stable ground. When the Fed wraps up its program, the economy and financial markets may wind up better off if it means oil, wheat and other commodity prices drop. "I've gone from being nervous to having my fingers crossed," he says.