What to Watch for As QE2 Ends

Now the economy will have to stand on its own.

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By the end of the month, the Federal Reserve will complete its second round of quantitative easing—often referred to as QE2—in which it's buying $600 billion worth of treasury bonds to push interest rates lower and kick-start the economy. The bond-buying program has come under fire from critics who say it has inflated the value of the stock market as well as commodities prices across the board—including the price of gas, which is still nearly a dollar higher than it was a year ago. At the same time, the economy has hit what economists call a "soft patch" following a number of weaker-than-expected economic reports, including a double-dip in home prices.

Now the economy is faced with what could be its biggest challenge yet: surviving without the Fed's stimulus. "It's high time we see whether the economy has legs of its own," says Liz Ann Sonders, chief investment strategist at Charles Schwab. As the program winds down, here are six things to watch for:

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Europe's sovereign debt crisis. After its credit rating was slashed again in June, Greece now has the world's worst credit rating. Default seems inevitable. "Greek debt has taken center stage," says Bill Larkin, fixed-income portfolio manager at Cabot Money Management. "Everyone is starting to plan for some form of default."

Rising treasury yields. One of the stated goal of QE2 was to keep interest rates lower, which generally encourages more lending and borrowing. As the end of QE2 nears, treasury rates are expected to begin to move to more normalized levels. Generally, treasury yields move upward as the economy recovers, but Greece's debt woes are causing investors to seek safety in treasuries, which keeps yields low. Until the situation is resolved in Europe, treasury yields could continue to be held down by sovereign-debt fears abroad. "Right now, treasury rates are being influenced more heavily by what's happening in Europe," says Stacey Schreft, director of investment strategy for The Mutual Fund Store, an investment firm.

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Stocks could wobble. Without a buyer as big as the Fed in the bond market, some experts are concerned that stocks could head south. Since Fed Chairman Ben Bernanke hinted at plans for QE2 in Jackson Hole, Wyo., in August 2010, the S&P 500 has risen by more than 20 percent. But the stock market has been in a bit of a tailspin in recent weeks. After posting six consecutive weeks of declines for the first time since 2002, the Dow Jones Industrial Average finished in the black again—barely—last week. Stocks performed poorly after the Fed ended its first round of easing in mid-2010, and Charles Biderman, CEO of TrimTabs Investment Research, says that could happen again. In a recent note to clients, he said: "Without the Fed constantly spiking the market's punch bowl, the path of least resistance for stock prices is down."

Hints of a QE3. After the end of June, the Fed will no longer buy treasuries, but it will reinvest proceeds from its earlier purchases. Experts expect the Fed to continue buying those proceeds until the economy looks healthier. The Fed hasn't hinted at a third round of easing, and Sonders says it would only institute one as a measure of last resort. "From a confidence perspective, the last thing we need right now is to be having a discussion about QE3," Sonders says.

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The Fed funds rate. The Fed funds rate has been at virtually zero for more than two years now, and since March 2009, the Fed has repeatedly said it plans on leaving rates low for an "extended period" of time. As the economy continues to improve, Sonders expects the Fed to ease off that language and begin to hint at a tightening of monetary policy. But in light of the economy's most recent slowdown, Sonders doesn't see a rate hike coming until at least the middle of next year. Instead of a third round of quantitative easing, Bill Gross, manager of the world's largest bond fund, PIMCO Total Return (symbol PTTAX), has said the Fed will continue to use the "extended period" language as a way of keeping rates low. "The language will be the new QE3," he says.