Ben Bernanke testified to Congress yesterday and sounded as doveish as usual. But with growing hawkishness on the FOMC and the political backlash against QE2 it strikes me that things would have to be pretty bad at the start of Q3 2011 for the programme to be extended. What does this mean for equities?

Based on the behaviour of the equity market under QE1, it means that they will keep going up until the start of Q3, and then fall back. In the latest round of QE, I have argued that risk assets would rise, but would experience volatility as the markets had jitters about this or that — because the QE effect is driven by real money flows, not constantly positive news flow. However, as QE1 went on, equities became less volatile, likely because the markets adapted to the new environment and stopped getting the willies over bits of bad news, and this seems to be what has happened under QE2. The only bad news that counts under QE is that QE is coming to an end.

So my view is now that markets will remain on a low-volatility upward trend until Q2. Logically, I should incline to be long the market until then, and out of it thereafter.

There are two risks to this view. First, on the downside, investors know what happened after QE1 came to an end — markets dropped and then drifted along in a range. Could the QE effect be overcome by investors anticipating the same reaction this time, and pulling out? If that happened, the sell-off could start sooner. Second, on the upside, continued strong economic data. Final demand increased at a rate of 7.1% in Q4 of 2010. If we are finally beginning a strong recovery, equities could continue upward after the end of QE2. They might then correct later as the economy slowed, or continue upward if the recovery becomes self-sustaining.