- The Post QE2 Financial Markets

The end of QE2 is upon us. In slightly more than a month the Fed will end its program of purchasing vast quantities of treasury bonds, and interest rates will begin to rise. No one knows how much they’ll rise exactly or when precisely that they’ll do it. But everyone … EVERYONE… who does this sort of thing for a living knows that rates will be higher after QE2 ends than they were before. The only people who claim anything else are those people who are hired specifically to pretend it isn’t so.

The reason for this is actually quite simple. Over the last year, the Federal Reserve was a buyer of over a trillion dollars in treasury debt, and the pace of federal borrowing isn’t going to change (well… it won’t be reduced anyway) so supply will remain constant. But without the Fed acting as the world’s largest purchaser, demand for that debt will be greatly reduced. The law of supply and demand will not be ignored – so prices for those bonds will fall and rates will rise.

But like most things in economics, there will be enough ambiguity in the reaction of the markets to muddy the waters a little. Instead of being direct and simple with cause and effect both clearly identifiable, it will be vague with enough volatility to leave any clear trend hidden for a while at least. This will empower the people whose job is to pretend that supply and demand are irrelevant when it comes to Treasury debt, and it will fill their quiver with what seem to be perfectly rational talking points to back that up. They’ll only be distorting things, not making them more clear – but that’s their job. So let me tell you what to expect to hear from them. First, some real world context.

The money that the Fed has spent on Treasury debt, hasn’t stayed in treasury debt. The financial institutions who’ve been buying up treasuries have used them as assets to borrow against. They then took that borrowed money and bought other riskier assets with them. In the quest to gain enhanced yield, they bought stocks, commodities, and other corporate and municipal debt. So when the Fed stops buying Treasuries the first thing we’ll see sell off will not be treasuries at all but the ‘risky assets’ they been used to finance.

Stocks will sell off first I suspect, since they are highly liquid. Then the commodity sector will begin to sell off too. This will probably lend relative strength to the dollar, giving liberals an important talking point. Then municipal and corporate debt will sell off causing those rates to rise relative to treasuries. This is referred to in the industry as ‘a widening of the credit spread’. That’s the watch word you’ll want to listen for.

Treasury debt will begin to sell off too – but it’s not going to do it right away or all at once. When you buy a Treasury bond you’re actually buying the expectation that the US government will be able to extract money from someone by force. That the US government can do that isn't really in doubt yet, so it's considered as sure a bet as it gets. This why treasuries are referred to as 'risk free'. It doesn’t actually mean that there is no risk associated with Treasury debt, only that it’s as close to it as anyone can manage.

So when other risky assets begin to sell off, if they do so rapidly, some of the money leaving those assets could very well flow into Treasury debt as a means of temporary protection. In fact, if the pace is high enough, we may even see rates fall temporarily. The empty headed media will say something like “QE2 ended X weeks ago, and over the last X days rates have actually fallen.” If you're listing for BS, you’d do well to notice the mismatch in relative time lines.

But a temporary reprieve won’t change the fact that the US government needs to borrow far more money than the capital markets can provide at current interest rates. Over time, rates will absolutely rise.

So what will change that? It will be one of two things. The first is that the Congress and the Whitehouse come to an agreement to slash federal spending. This would cause the supply of Treasuries to fall, and with demand unchanged, this will stabilizing interest rates. But with generations of pols having made their way in the world by taking tax money from the productive classes and using to buy votes, most people would call that scenario ‘unlikely’.

The second thing that might change this is if rising interest rates begin to inhibit economic growth. Since this is the practice the Fed uses if it WANTS to inhibit economic growth, there isn’t a lot of doubt about it. And as growth slows, it will cause economic statistics to soften and unemployment to rise. This will inevitably act as justification for a new policy of quantitative easing – or QE3. Then, as the Fed returns as the biggest buyer of Treasury debt, rates will once again stabilize.

Right now the political opposition for QE3 is very strong. But if the economy begins to point toward a new recession (one that Obama won’t be able to blame on George Bush) that will reverse in a heartbeat. The media will be more than happy to comply, and they’ll dredge up the talking points I mentioned above as a rationalization. There will be a diminishing return on QE3 relative to QE1 or 2, and you’ll hear talk of ‘running on a treadmill’ or hyperinflation from the opposition. But these are easy charges to ignore as ‘extreme’ and the media will be happy to do so.

Besides, with both Democrat and Republican presidential candidates out there promising more cake and circuses in exchange for votes, there will be lots of people with an interest in pointing at libertarians and calling them ‘crazy’. It will once again be portrayed as Democrats and reasonable ‘centrist’ DC insider Republicans standing up to the ‘extremist’ (and racist) wing of the ‘Tea Party’ right. It will be portrayed as rational insider DC policies vs. slash and burn fanaticism.

So the post QE world will involve the sell off of all assets, not just Treasury debt, and it won’t happen all at once. It may include the dollar strengthening against other currencies as well as against commodities like gold and silver, and will involve a widening of ‘credit spreads’. There may even be short periods where interest rates fall due to ‘risk off’ momentum trading. Much of this will be portrayed by the brain dead media and the hired guns of the left as evidence that everything is fine. But it won’t be. Over time, rates MUST rise.

And when they do, it will set off the next round of QE... and the next, and the next and the next. Our economy isn’t growing nearly fast enough to get us off this treadmill. And the further we go down this road, the harder it will be to do so in the future. Eventually it will become mathematically impossible to do so.

But this will continue for the time being anyway…until either the federal government gets its fiscal house in order, or the whole thing falls apart. Those are the only two long term options.