What happens when QE2 ends in June?

No one knows for sure what will happen when QE2 ends on June 30, but here’s my best bet: it won’t be pretty.

Call it D-Day; “D” for decline. On June 30, the Federal Reserve is expected to close the door on its enormous quantitative easing program QE2. No one knows for sure what will happen, but there seems to be a general consensus that markets are going to get volatile. Here’s my take:

Look for a sell-off in stocks. With the Fed pumping as much as $2.5 billion into the economy every day since November, it makes sense that equities have been on the rise – particularly as short-term bond yields flirt with near-negative rates (when adjusted for inflation). Once the cash spigot shuts off, a big support for the markets will be kicked free. Runaway oil prices have already started digging a rut in economies around the world. That prompted analysts at Goldman Sachs last week to urge clients to go underweight commodities in the near-term.

Inflation’s not over yet. Keep in mind that the Fed’s goal with QE2 was to stave off deflation. With inflation near 10 percent (per ShadowStats), they’ve clearly achieved what they set out to do. However, ending QE2 won’t immediately lead to a wave of deflation. Inflation spiked in Japan for more than five months after the government officially ended its QE experiment in March of 2006. Stocks, however, collapsed, and the Nikkei took more than a year to recover.

Bond yields will shoot for the sky. Without a rigged auction system, bond buyers could be in short supply come July. If that’s the case, prices will fall and the yields on U.S. treasuries will likely spike. Japan experienced something similar during its VaR Shock in July of 2003. At the first sign of weakness in the bond market, risk models triggered heavy bond selling by banks and other financial institutions in the country. The net effect was a tripling of bond yields in three months. A similar sell-off in the U.S. could potentially trigger sovereign debt fears of the sort we’ve seen in Europe.

Precious metals cool. I’m definitely bullish on gold and silver for the long haul, but I’m still haunted by 2008’s 28 percent sell-off in gold during the height of the financial crisis. If we do see an all-out panic, investors could lose faith in just about every investment vehicle on the planet – including precious metals. Still, I’d look at any metals sell-off this summer as a buying opportunity – not an opportunity to go short. The volatility in the metals markets could be enough to crush even the most steadfast investor.

VIX ETF funds could make you money. If there is blood in the streets come June 30, the best place to park your cash might be in a volatility-based ETF. The iPath S&P 500 VIX Short-Term Futures ETN (Public, NYSE:VXX), for instance, tracks the Fear Index by investing in futures. When markets get choppy, VXX outperforms. Rather than churn and burn your way through cash, invest in fear and uncertainty itself. After all, uncertainty about the future is about the only thing investors can agree on right now.



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