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As the easy money ends, an uncharted road lies ahead

File photo of U.S. Federal Reserve Chairman Ben Bernanke.

JASON REED/Jason Reed/Reuters

For the past eight months, the world's stock and commodity markets have gone on a tear, thanks to the U.S. Federal Reserve Board.

Through its program of quantitative easing, the Fed has pumped nearly $600-billion (U.S.) of fresh cash into the U.S. financial system. As is typical when lots of extra money sloshes around markets, happy results have followed - most notably, soaring prices for nearly everything, from gold, which this week reached a record $1,500 an ounce, to stocks, which are nearing some of their highest levels since the 2008 financial panic.

But now, as the program enters its final phase, a moment of truth is looming for markets and the world economy. Over the past two years, whenever the Fed has opened its monetary spigots through quantitative easing, stocks and commodities have soared, brightening the outlook for the recovery. Whenever the Fed has stopped, markets have stalled, or gone into reverse, darkening the prospects for the economy.

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Can the market remain in rally mode, and the U.S. economy continue its upturn, without the support of quantitative easing? Market players have strong opinions. The trouble is, their views are some of the most divided ever seen on a major financial issue.

Quantitative easing was intended to promote a stronger recovery and ensure that inflation doesn't get too low. The key part of this unorthodox program involved the Fed buying huge amounts of U.S. government debt, and through the alchemy of modern central banking, paying for it with money created out of thin air. (The first round of quantitative easing, so-called QE1, was launched during the 2008-09 panic; a second round, QE2, was announced in late August, implemented in November, and is slated to wrap up in June.)

Some strategists, such as U.S. bond fund maven Bill Gross, contend that an end to the Fed's massive purchases of bonds means that interest rates, which move in the opposite direction to bond prices, are sure to soar. In response, he's dumped his U.S. Treasuries, which would be hurt by such an interest rate spike.

Others surveying the same financial landscape have come to the opposite conclusion. They believe that once the Fed stops printing money, inflation expectations will diminish, leading to falling rates and a pricking of the commodity bubble that has been so important to the Canadian economy and stocks. Still others believe the U.S. economy is in a self-sustaining recovery strong enough to advance without further monetary hand holding.

Views are just as diverse on the merits of the QE2 program itself. Some believe it has been a misguided flirtation with inflation; others see it as a rational attempt to calm unsettled markets after the trauma of the crash.

In the QE2-is-monetary-madness camp is Lacy Hunt, economist at Hoisington Investment Management Co., an Austin, Tex.-based money manager that specializes in bond investments. He views QE as little more than a central-bank-run free lunch program for Wall Street and speculators.

"I think the main thing to do is end QE2 and not ever try such a harebrained scheme again. I mean, it's untested and the results were a net negative," Mr. Hunt contended in a recent interview.

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He believes the U.S. must start growing without monetary gimmicks if it's going to have any hope of regaining prosperity. "The economy has to stand on its own. ... That's what it has to do here."

In Mr. Hunt's view, QE2 helped drive up the prices of necessities, such as food and gas, by flooding cash into the financial system. The money has fuelled a bout of commodity speculation that has eroded the buying power of incomes in the United States for all but the richest households, who've actually profited through their stock and commodity holdings.

Contrary to expectations, QE2 also led to higher interest rates because it revived inflation jitters, which more than outweighed the downward pressure on rates resulting from the Fed's purchases of bonds. Higher rates have undermined the housing market by making it more expensive to finance a home, contributing to the downward pressure on house prices, the most important investment for the majority of families.

When QE2 ends, there will be "some diminishment of the upward pressure on stocks and commodities," Mr. Hunt says. He's looking for interest rates to fall, making bonds attractive.

But those forecasting higher rates are equally adamant. Pierre Lapointe, global strategist at Brockhouse Cooper, a Montreal-based brokerage house for institutional investors, wonders who will buy U.S. Treasuries when the Fed stops. The Chinese have recently cut back on their bond purchases, and the Japanese are likely to become sellers to finance earthquake reconstruction. In recent months, purchases by the Fed have covered nearly all of the U.S. federal deficit.

Mr. Lapointe says "rates will have to be higher than they currently are," possibly more than half a percentage point, to attract buyers and he has been telling investors to lighten up on bonds. But he doesn't think a stock market correction will follow because the economy is improving, as are corporate earnings.

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"I think the quantitative easing program was justified" when it was announced in late August, Mr. Lapointe said. European markets were then in disarray over sovereign debt default fears, a spooky flash crash had rattled investors, and there were fears at the Fed that deflation might take hold.

Others believe that QE2 hasn't really solved anything. Standard & Poor's this week placed a negative outlook on the triple-A credit rating carried by U.S. government bonds. Worries over massive U.S. deficits have been accentuated by the Fed's loose monetary policy, which in turn has prompted a flight from the U.S. dollar, the world's reserve currency.

Fairfax Financial CEO Prem Watsa told shareholders at the company's annual meeting this week that he still thinks deflation lies ahead, regardless of the Fed's activities. "These are the same guys who said that the real estate market was not going to have a problem because America's prosperity was doing well, [the]same guys who recently with the QE2 said that long rates were going down not going up. They actually went up. ... So we continue to be worried."

With a file from reporter Tara Perkins.

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About the Author
Investment Reporter

Martin Mittelstaedt has had a varied reporting career at the Globe and Mail, covering politics, the environment and business. He opened up the Globe's New York bureau for the Report on Business, and has also been on the banking and capital markets beats. He's written extensively on investing themes. More

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