Three Reasons Why Markets Will Correct After QE2, No Matter What

The US GDP number was out yesterday.  I trust many people have talked and written about that, so I am not going to repeat.  I will turn to quantitative easing.  As the Fed will have their FOMC meeting next week, all investors will be nervously looking at the actual scale of QE2.

A friend of mine told me a rather amusing arguments on what will happen after the FOMC announcement.  Here are 3 scenario:

1. No QE2, or QE2 less than expected

2. The scale of QE2 as expected

3. The scale of QE2 larger than expected.

First of all, how much of QE2 do people really expected?  It seems the opinions are rather divided, as Reuters poll showed that dealers expected some $250bn to $2 trillion, with the average expectation of about $80-100bn per month.  Let us just assume the expectation of the average investors in the market is in-line with these dealers, what will happen?

In scenario 1, as my friend said, investors will be disappointed.  That is a no-brainer, of course if the actual number is less than expected, investors will be upset, and stocks will drop, commodities will drop, and US dollar will rise.

In scenario 2, there should be little impact theoretically, if the expected amount of QE2 has been fully discounted.  But there is a catch: the stock markets have been rallying for almost two months.  If the actual QE2 cannot provide surprise on the upside, he could not see how the market would react in a neutral way, because the markets are poised to correct at such high level:


In scenario 3, this is the most interesting part.  If the actual QE2 is larger than expected, he said, the market will probably think “hm… it looks like the Fed thinks that the economy is very bad!”.  The stock markets will drop.

His conclusion: no matter how much money the Fed put in, the stock markets have to correct.

That is a rather amusing argument.  But indeed, for the financial markets, sometimes it is not about the actual numbers.  Rather, it is about the story.  Now it does not really matter if the prediction of the size of QE2 is correct.  As long as the market reacts, analysts will make up some stories after that.

I agree that the stock markets are at a rather high level.  The global economy is not doing well, and there are risks all around.  I cannot see the reason why the stock markets are doing so well, while the economy is still struggling to recover, except that there are a lot of liquidity.  Instead of making whatever QE2 amount as bad news, I guess there will be some nasty stuff which the market has ignored for two months, and it will come back and bite us again (example).

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