QE3: Beginning Of the End?

Long-derided by Austrian economists and inflation hawks everywhere, quantitative easing (QE) has been the Federal Reserve's primary tool for combating the devastating effects of the Great Recession. First enacted in 2008, the Federal Reserve has purchased trillions of dollars in Treasury bonds and collateralized debt obligations — specifically mortgage-backed securities. QE1 saw the Fed expand its balance sheet from between $700bn and $800bn in Treasury notes before the crisis to some $2.1 trillion in Treasuries and mortgage-backed securities it had purchased from financial institutions by June 2010.

Not content with the pace of the recovery, the Fed commenced a second round of easing in November in 2010. Under that iteration, the Fed bought $600bn in long-term Treasuries and reinvested nearly $300m from the proceeds of bonds it had previously bought. The aim of the program was, and remains, to drive down Treasury yields and discourage safe-haven investing.

This chart explains the correlation between the implementation of rounds of QE and the S&P 500.

After the unwinding of QE1 and QE2, the market experienced corrections as the Fed withdrew the stimulus, which has an inherent inflationary effect. By increasing the amount of dollars in circulation, asset prices rose. Each time the Fed announced it would cease pumping money into the economy via permanent open market operations, traders by and large became bearish on stocks and commodities. 

A trimming of the bond-buying program currently in place is unlikely to rattle markets, as a $10bn-$20bn reduction has already been priced into the market. However, if it goes beyond this, or if the Fed indicates it might be willing to terminate the program completely sooner rather than later, stocks could be in for a jolt  

QE is meant to shore up banks' capital and spur lending by freeing them of toxic mortgage derivatives, which were in demand in the run-up to the crisis. Many of those securities, however, were backed by subprime loans, which were also partly responsible for the housing bubble.