QE3 or Bust: What Happens If The Fed Lets Up On The Accelerator?

02-14-2011 • OfTwoMinds.com/blog

The stock and bond markets now depend on massive injections of free money (via the Fed's POMO) into equities and the purchase of newly minted Treasury bonds. This is the ratchet effect on a large scale: any attempt to ratchet down the Fed's interventions will cause uncertainty and doubt about the consequences, for no one seriously believes that private demand is just aching to jump in and replace the Fed's trillion-dollar buying sprees in stocks, bonds and mortgages. Beneath the surface of illusory stability, pressures are mounting. A stock market which is now entirely reliant on monthly injections of $100 billion of "free money" from the Fed's "quantitative easing 2" program is a market that is exquisitely vulnerable to any reduction in that stimulus. The same can be said of the bond market, which globally is groaning under the demands of sovereign states borrowing trillions of dollars annually in new bonds from now until Doomsday (roughly 2021, last time we looked, though many see 2012 as the end-game). If the Fed stops buying Treasuries, then rates--already rising on the long end--will move decisively higher, bollixing the Central State's entire game plan of rescuing the insolvent banks and goosing a "recovery" with low interest rates and unlimited liquidity. The Fed and Treasury are now boxed in by the ratchet effect. Any reduction in the Fed's unprecedented intervention, no matter how modest, will trigger an earthquake of uncertainty: the apparently "sticky" stability will slip in a dislocation. The problem with expectations is also a reflection of the ratchet effect: they only go up. Rather than adapt and evolve, the Central State and its proxy the Federal Reserve simply moved into a higher state of vulnerability.