What the End of QE2 Means for the Market

By Josh Lipton, Minyanville

NEW YORK (Minyanville) -- The Federal Reserve is scheduled to end its extraordinary program of support for the economy in June, but market participants debate whether policymakers will ultimately decide to deploy additional monetary stimulus to continue this stock market rally and, just as critically, what will happen if they do not.

Some strategists argue that the S&P 500, which is now about 5% off its February 18 peak, could very well experience a steady erosion of gains just as it did last year when the first round of quantitative easing (QE1) came to a close. With the conclusion of QE2 less than four months away, say the bears, this stock market could again suffer a nasty tumble.

More from Minyanville Fund Managers Say Stick With Tokyo The Technical Case for a Continued Bull Run Bahrain: Oil Price Flashpoint?

Federal Reserve Chairman Ben Bernanke, when he launched another round of bond buying last fall, had twin objectives. Firstly, he wanted to drive down long term interest rates. Low yields would supposedly stimulate the housing market, business investment and overall economic activity.

The yield on the 10 year note, which serves as a benchmark for consumer and corporate borrowing, rested at 2.64% on August 27 when Bernanke first opened the door to more bond buying. Today it's at 3.26%.

However, Bernanke and his allies on the FOMC, in pushing ahead with such monetary stimulus, also explicitly intended to drive investors back into risky assets such as stocks. Bernanke wrote about the issue in the Washington Post last November and even recently mentioned the rally in the Russell 2000 during an interview on CNBC.

If investors see the value of their stock portfolios rise, so the thinking goes, then they will feel more confident and inclined to spend. Businesses, reacting to that demand, will start hiring again and help bring down the unemployment rate.

Here, Bernanke certainly accomplished his objective. Reacting to all that easy money right on cue, the S&P 500 rallied 20% between August 27 and February 18.

However, investors must now prepare for the scheduled conclusion of this Treasury securities purchase program. The question, for investors, is what happens when the Fed stops flooding the financial markets with money. Some strategists have warned that, using recent history as a guide, the likelihood of a stock market selloff seems like a good bet.