Quantitative easing is the practice of purchasing Treasury securities (thereby creating a demand for Treasuries) from the open market. To purchase them, the Fed creates dollars, which go out on the market. Fed purchases would keep 10 yr yields (and thereby interest rates) low in order to stimulate the housing market and spark consumption.
At the same time, this practice has weakened the dollar substantially thereby causing hard assets such as oil and gold to rise. Additionally, it also created an inflation premium in the market as investors expected large inflation down the line if the recovery did indeed take hold.
The fed has announced that the plan would be suspended as planned in September. This announcement, while mostly underreported and unnoticed, could have profound consequences over how the market reacts in the next couple of months.
Due to the implicit drop in demand for Treasuries from the gov’t, two important impacts could take place. For one, interest rates will have one big reason to go up from here if the recovery does indeed begin to take hold. A decrease in demand for Treasuries, coupled with continued massive issuance from the gov’t should send yields rising. However, this in itself creates the very force that would doom the recovery. An increase in 10 yr yields will surely increase borrowing costs for consumers ranging from mortgage rates to credit card bills. The stabilization in housing could be undermined and consumption would be curtailed.
A second factor to consider would be the effect the decision would have on the dollar. The dollar, which has weakened considerably over the last couple of months, would have a large bullish catalyst at its back, a substantial decrease in the amount of dollars printed.
These two reasons, when joined together, could set up the market for some downward pressure in the next couple of months. Inflation expectations would recede, causing the value of oil, hard assets, and even the stock market (which has priced in an inflation premium) to go down. Couple this with a stronger dollar and this would further strengthen the argument for lower commodity prices. Frankly I believe that this latest bull market has largely been a result of liquidity, not actual fundamental improvement.
Shut off the dollar spigot, and we could truly see if this rally is real or not. Only time will tell, but in my view, I believe the Fed has removed the band-aid on a would that has yet to heal.