In just a couple months, the US Federal Reserve's second quantitative-easing campaign will wind down. This program has been highly controversial since its birth, so the Fed is under tremendous pressure not to launch a third round of QE. And if QE2 indeed ends on schedule this quarter, it has major implications for the US stock markets.

Central banks around the globe are notorious for trying to cloak their actions. One of many ways they obscure their activities is by coining new phrases to name them rather than using classic historical terms. Quantitative easing is a pleasant-sounding euphemism for the dangerous practice of debt monetization. The Fed is creating massive amounts of new money out of thin air to buy bonds.

When normal investors buy bonds like US Treasuries, they have to first sell something else to raise the cash to make the purchase. The money supply doesn't change at all. But when the Fed buys bonds, it finances its purchases by conjuring up new dollars that never existed before. This new fiat currency is pure inflation, an increase in the money supply that is injected into the economy the moment the bond issuer spends it.

The goal of converting debt into new money is simple, to manipulate financial markets. The Fed doesn't even try to hide it, Chairman Ben Bernanke and the rest of the Fed leadership openly discuss this mission. By buying bonds with newly-created fiat money, the Fed is actively trying to drive down interest rates by increasing bond demand.

Remember how bonds work from Finance 101? When they are first issued, they have a contractually-set yield. For example, a bond might originally cost $1000 and pay 6% interest annually over its lifetime. But after this bond is first bought from the issuer, it can be sold in the secondary marketplace. The higher the demand for it, the higher its price is bid. Even if it gets up to $2000, it still only pays 6% on its original $1000 face value. Thus its effective yield for a new buyer has fallen to 3%. Buying bonds drives their prices up and yields down.

Bond prices and effective yields move inversely. So the higher Fed buying pushes up bond prices, the lower their yields fall. And when our central bank is using the currency it creates to buy our own government's sovereign debt, this price-yield dynamic drives down all interest rates. US Treasuries, considered "risk-free" since the US government can print infinite new dollars to ensure it never technically defaults, form the foundation from which all other interest rates are set.

Conspiracy theorists endlessly rant and rave about many markets, but hypocritically ignore this biggest and most-blatant market manipulation of all. By monetizing US Treasuries, the Fed is actively manipulating almost all interest rates in our entire economy. As in all manipulation schemes, this causes great distortions and misallocations of resources. Just one example is robbing savers blind. Thanks to Bernanke's Fed, we're not earning a fair return on our hard-earned capital. Why should the Fed steal from savers to subsidize debtors?

The Fed embarked on this unprecedented Treasury monetization, which it happily calls quantitative easing, for a couple key reasons. The Fed only directly controls a couple interest rates, the federal-funds rate and the discount rate. The former is what private banks are paid to lend money through the Fed to other private banks, while the latter is what private banks are charged for borrowing directly from the Fed itself. The problem is both of these rates are very short-term, usually just overnight in duration.

Manipulating overnight rates usually does little for the long end of the yield curve, interest rates for debt maturing over years or decades such as car and house loans. But monetizing Treasuries enables the Fed to directly manipulate long rates, forcing down borrowing costs (and savings income) in the entire economy. On top of this, the Fed had already driven its own short rates to zero when it originally started quantitative easing.

Back in late 2008, the first true stock panic in 101 years crushed the global stock markets. In October alone, the flagship S&P 500 stock index (SPX) plummeted 30% in just 4 weeks! This epic bloodbath drove widespread fears of a new global depression, which the Fed wanted to fight at all costs. So on December 16th, 2008, the Fed's Federal Open Market Committee slashed its overnight federal-funds rate by over 0.75% to an unprecedented "target range" between zero and 0.25%.

With its primary interest rate already at zero, the Fed had expended all its normal ammunition with nothing left for the future. Its only option left was to directly buy securities, artificially boosting demand by creating new US dollars out of thin air to monetize assets. Thus "quantitative easing" was born, a desperate last-ditch strategy historically used by third-world banana republics just before their currencies fail and hyper-inflate. It was a sad moment for the world's biggest central bank managing the world's reserve currency.

This first chart highlights the Fed's monetization since this fateful decision was made in late 2008. The Fed's total balance sheet, including all the securities it was buying, is shown in orange. The main types of debt it purchased are US Treasuries (red), mortgage-backed securities (yellow), and agency debt (green). Note that these three QE components are shown in area fashion, stacked on top of each other. The red Treasury series, for example, does not run from zero but from the top of the yellow MBS series.

While it wasn't yet called quantitative easing, this whole inflationary monetization was born on November 25th, 2008 several days after the primary stock-panic low. Even though the SPX had already bounced 13.9% higher, the Fed announced it would purchase up to $500b of mortgage-backed securities issued by Fannie Mae, Freddie Mac, and Ginnie Mae to attempt to ease up credit for the housing market. It also said it would buy up to $100b of bonds directly from these government-sponsored enterprises, GSE agency debt. It said these purchases would take several quarters.

Realize that the stock markets are the key to the entire economy. When they are rising, everyone feels better and more optimistic regardless of whether they are an investor or not. When they are falling, everyone feels worse and more pessimistic so they slow down their economic activity. There is no doubt the post-panic stock markets would have bounced sharply higher anyway, but the Fed hoped its initial foray into monetization would accelerate this process.

And indeed in December 2008, the stock markets stabilized and started climbing again. But in January and especially February 2009, this recovery process ground to a halt. The new Obama Administration was terrifying investors with its Marxist plans to socialize medicine and radically raise already-crushing income taxes on the investors, entrepreneurs, and small businessmen who create most of the private-sector jobs in America. So the SPX plunged sharply again on this Democrat Despair, falling 25.1% year-to-date by early March.

Once again the Fed panicked, worried that the dismal stock-market action would scare and depress Americans into seriously reducing their spending. This would have spawned a depression. So on March 18th, 2009, over a week after those secondary lows in which the stock markets had already naturally bounced 15.0% higher, the Fed formally announced what is now known as QE1. It brazenly told the world it was going to monetize debt to flood the economy with new money and drive down interest rates.

In that fateful day's FOMC statement, Bernanke and his merry band of market manipulators said they were going to conjure up another $1150b out of thin air to buy various securities! This broke down as $750b more of mortgage-backed securities, $100b more of agency debt, and for the first time ever $300b in "longer-term Treasury securities". It gave a timeframe of 6 months to complete these Treasury purchases. This announcement pushed QE1 up to its staggering total of $1750b (nearly trillions)!

Make no mistake, the financial markets knew this was a pure-inflation monetization. Within 15 minutes of this announcement, gold rocketed from the low $890s to over $930. The US Dollar Index plummeted 2.9%, its biggest daily slide in its entire quarter-century history at that point. There was no doubt in any sophisticated trader's mind that quantitative easing was anything but a blatant monetization of debt. It was truly a shocking announcement!

As you can see in the chart above, as the Fed made good on its QE1 announcements its balance sheet swelled dramatically. Averaging around $870b in the first half of 2008 before the panic, it nearly tripled to $2250b by the first quarter of 2010! You can easily see the radical ramp in the Fed's holdings of US Treasuries, mortgage-backed securities, and agency debt. All of this freshly-created money had to go somewhere, so way over a trillion dollars of new fiat paper flooded into the real economy.

Obviously Washington spends money like a drunken sailor, living far beyond its means. So when the Fed buys Treasuries from it, these new dollars are immediately spent on all the things the federal government does from paying federal employees to writing welfare checks to waging wars. Via this monetization mechanic, especially in terms of Treasuries, the Fed was rapidly inflating the real US money supply.

Because of the way I constructed this area chart (above), the top of the red Treasury series represents the total Treasuries, MBSs, and agencies the Fed purchased in its quantitative-easing campaigns. That red line above is transferred to the second chart below as total QE. And superimposed on top of it is the US stock markets as represented by the SPX (blue). The strong correlation between the Fed's monetization and the post-panic stock-market recovery is remarkable, perhaps even scary.

Now as a free-markets anti-government-intervention guy, I fully believe the US stock markets would have recovered just fine (probably even better) without all Washington's interference. But regardless of where you stand on that, the very tight correlation between the Fed's QE and the US stock markets is amazing. Keynesian Socialists, who paternalistically believe government knows best, could sure argue that the Fed's gargantuan injection of pure inflation drove the massive post-panic stock-market cyclical bull.

It is provocative that when the Fed's balance sheet started shrinking again in the second quarter of 2009 as QE1 ramped up, the SPX entered a sharp 7.1% pullback. At that time the Fed was transitioning from activities like discount-window lending that ballooned its balance sheet during the panic to its long-term debt-monetization campaign. The SPX resumed rallying right when the Fed increased the tempo of its Treasury purchases and started growing its massive balance sheet again.

By early 2010 the Fed had maxed-out its $300b in advertised Treasury purchases, which only left MBSs. It is provocative that as the Treasury monetization flat-lined, the SPX sold off again in what became its biggest pullback of this entire cyclical bull. While the stock markets soon recovered, not long after they entered their only full-blown correction of this entire bull in the spring of 2010 right as the Fed's balance sheet stalled and started to shrink. The SPX fell 16.0% during this timeframe, which is provocative.

Once again as a free-markets guy, I think this correction was due anyway regardless of the Fed's activity. That selling episode started a couple days after Transocean's now-infamous Deepwater Horizon drilling rig sunk in the Gulf, and it included the brutal Flash Crash of early May. Both of these events really frightened complacent investors, and had nothing to do with the Fed. Still, it is fascinating to see the SPX remain weak for months beginning right when the Fed's balance sheet started to shrink.

By the Fed's next QE announcement on August 10th, 2010, the SPX was already recovering nicely out of its correction and up 10.3% from its early-July low. The Fed actually spooked the markets that day, announcing what would become known as QE2. It reneged on a critical QE1 promise that it would let those debt purchases automatically unwind as they matured. That day it announced it would roll over $300b in maturing MBSs into long-term Treasuries. Again the markets recognized this monetization and knew it was an attempt to manipulate long interest rates. The SPX plunged 2.8% the next day, as traders wondered why the Fed was re-launching QE despite the obviously-improving US economy.

As the Fed started buying Treasuries again, the stock markets rallied sharply into early November. On November 3rd, the day after the landmark 2010 elections which saw record Democrat losses in the federal and state legislatures, the Fed formally launched QE2. It said it planned to buy another $600b in US Treasuries by the end of the second quarter of 2011. This was on top of the $300b it was rolling over into Treasuries from maturing QE1 MBSs. So the FOMC essentially launched a $900b monetization of US sovereign debt!

Now QE2's $900b total may seem moderate compared to QE1's $1750b, but this direct comparison is misleading. In QE1 the Fed only bought $300b in Treasuries, manipulating long rates and effectively injecting pure inflation into the US economy. Since it got away with QE1, the first US debt monetization in modern history, it focused QE2 exclusively on Treasuries and tripled their buying to $900b! It was going to drive long rates lower through artificial demand regardless of the costs, inflation be damned.

Provocatively again, the SPX was in a minor pullback (the smallest of this cyclical bull) when this announcement was made. While the Fed promptly started printing money fast and furiously to buy more Treasuries, the stock markets started climbing rapidly. Once again the ascent curve of the SPX in 2011 matches the fast ramp in the Fed's total quantitative easing nearly perfectly. If the Fed had not launched QE2 would the stock markets still have rallied this year? Maybe, but certainly not as much.

Overall, the correlation between the US stock markets and the Fed's monetization is very tight and rather remarkable. When the Fed is creating new money out of thin air, it is only natural that some of it would find its way into the stock markets. And provocatively, whenever the Fed slowed the growth of its balance sheet or backed off on Treasury purchases, the stock markets promptly pulled back or corrected. This phenomenon is hugely important today since QE2 is scheduled to finish by the end of June, two months!

How will the US stock markets react to the end of quantitative easing? Will long interest rates start to climb dramatically after the Fed is done monetizing US Treasuries? The world's biggest and best bond-fund manager, billionaire Bill Gross, has pointed out that a whopping 70% of the annualized issuance of US Treasuries since QE2 began has been purchased by the Federal Reserve! Will the usual buyers (China, Japan, other sovereigns) triple their purchases going forward to make up for the Fed's absence?

Last week I wrote about all the sentimental reasons (excessive greed and complacency) why the stock markets are overdue for a correction. In addition, the SPX is very technically overbought (has rallied too far too fast). If you want a fundamental reason on top of all this, the end of QE2 is certainly it! The stock markets have really struggled in this recovery when the Fed slowed its monetizations, and of course higher interest rates are bad for the stock markets as they make bonds look relatively more attractive.

Immediately when QE2 was formally announced in early November, the Fed came under blistering condemnation from central banks, political leaders, and investors across the globe. It was an amazing reaction that shocked the Fed, and put intense pressure on it to end QE2 prematurely. Debt monetizations are always bad news in the long run, injections of pure inflation that wreak all kinds of havoc down the road. Given the loud and atypical uproar over QE2, a QE3 is extremely unlikely.

So the Fed's crazy-bloated $2643b balance sheet is due to start shrinking in a couple of months on the outside, maybe sooner. And one of the key functions of stock markets is to anticipate future impacts of everything imaginable, especially something as big as the QE2 monetization. So at some point well before the end of June, traders are going to get nervous about the upcoming end of the Fed's inflation injections and start selling stocks. The closer the end of QE2 draws, the brighter this anxiety will flare.

Even if the end of quantitative easing doesn't have a tangible impact on capital flows into the markets, which is all but impossible, it is definitely going to have a massive psychological impact on stock and bond traders. They are soon going to start preparing for the end of QE2, moving capital out of harm's way which is going to affect the stock markets, bond markets, currency markets, and commodities markets. Everyone knows this QE2 deadline is looming, and they know they need to prepare earlier before others to realize the best prices.

At Zeal we are certainly ready. In recent months we've realized huge gains in our stock trades purchased last summer before the SPX blasted higher in its latest upleg. Heavily in cash, we are ready for a correction and eagerly look forward to buying the subsequent bargains afterwards. While there are plenty of sentimental and technical reasons why the stock markets are due to correct, the end of QE2 adds a massive high-profile fundamental reason that few prudent traders will risk ignoring.

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The bottom line is the US stock markets have had a very-strong correlation with the growth in the Fed's quantitative-easing campaigns. When the Fed has been monetizing debt aggressively, the stock markets have rallied. But when it has pulled back and its balance-sheet growth stalled, the stock markets have languished. Whether there is a direct inflationary causal link or not, this correlation is super-important psychologically.

Traders know the end of QE2 is nigh, and that QE3 is very unlikely given all the heat the Fed has taken over QE2. The only way QE3 will fly is if the stock markets tank dramatically. Odds are traders will sell stocks in anticipation of the end of QE2, probably well before late June to beat the rush and realize the best prices. And long interest rates are likely to rise considerably once the Fed stops buying Treasuries as well, which is not a good omen for stocks.