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If the Fed backpedals on QE it would instantly crash the bond market so this is not going to happen

Posted on 06 January 2013 with 2 comments from readers

Gold and silver sold off sharply at the end of last week and stocks hesitated to resume their New Year rally on news that the Federal Reserve’s top committee is divided over continuing QE. But whatever their reservations the Fed really has no alternative but to continue its bond buying program or the giant US T-bond market would crash.

Perhaps this will be a pattern going forward this year: a few doubts from the Fed minutes to put the wind up markets and then some more dovish noises and actions puts humpty dumpty back together again.

Who’s buying bonds?

Say the Fed was to stop buying 10-year US bonds. As the Fed is buying around 60 per cent of these bonds presently then demand would fall, interest rates go up and bond prices crash. It would be a huge blow to bondholders and interest rates would have to go still higher to attract buyers. The impact on economic activity would be appalling.

Could the Fed just slowdown its bond buying program? Then you would get the same story only perhaps more slowly until the market really lost its nerve.

No having gone down this particular road, kicking cans down it all the time, the Fed is stuck with no way out but more and more QE. Now and again the financial markets may have to remind the Fed just how much they need this stimulus.

It would be surprising perhaps if some Fed committee members were not losing heart. The Fed balance sheet is expanding far faster than the miserable recovery in the US economy.

No way to stop QE

However, a policy that staves of the worst and offers some hope is probably better than one the results in instant depression and economic implosion. We are also far from sure that this strategy will eventually bring about a solid recovery in the US – fighting a debt bubble with more debt never looked that clever but it’s more immediately palatable than the alternative.

In the 1970s the world stumbled though a similar phase of low growth and high unemployment with the printing presses running flat out. Eventually in 1980 the Fed felt the economy was strong enough to withstand the shock of higher interest rates but we seem years away from being in that position, if indeed it can be achieved this time.

Reality and past precedent will restrain the Fed from abandoning QE anytime soon whatever committee members may say in their discussions.

Posted on 06 January 2013 Categories: Banking & Finance, Bond Markets, Global Economics, Gold & Silver, US Dollar, US Stocks

2 Comments posted by readers:

Comment by boatman - 06 January 2013

good article.

‘volckerizing’ the FED rate as per 1980 is impossible these ‘debt’ days…………tall Paul himself has said so.

the WEST+JAPAN credit/debt/entitlement bubble has no resolution without a great financial reset and this was baked in the cake years ago……but such is the nature of homo sapiens……..we do not have as muich control over our nature as we think we do.

we get alot closer to that this year.

Comment by John Mark - 06 January 2013

Ed, does the inevitability of QE, as you have just described, mean that the Fed is destroying the value of the dollar? That the benefits of avoiding disaster now mean that the dollar is heading for worthlessness?

If so, does this mean that dollar hyperinflation is bound to appear at some time in the future, because the dollar will be experienced as valueless by a rapidly increasing number of Americans at that time?

The can down the road staves off depression and economic implosion now, but becomes hyperinflationary depression and economic implosion then.

Ed Note: Yes.

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