Will bond or equity markets crack first under QEII?

By printing money the US Federal Reserve is devaluing the US dollar and thereby the value of US bonds held by foreigners. If the dollar drops sharply in value as it has over the past few weeks, then the tiny interest payments on bonds make these far from safe assets. The bond holders are losing money.

Pimco, the largest US bond fund, says the bond rally is almost over. The Chinese have cut their US bond holdings by more than 10 per cent over the past year. Yet the buyer of last resort, the Fed itself has kept the bond market aloft. This will not work for much longer. Even old Alan Greenspan warned as much a week ago.

Tipping point

Soon the cost of servicing these debts is going to reach a tipping point. For beyond a certain point any debtor is in trouble as they have to borrow bigger and bigger amounts to pay their interest until the loan starts to mushroom in size.

At the same time the excess liquidity created by money printing or quantitative easing as it is called, is blowing up a bubble in global stock markets. Nothing in the global economic outlook justifies these price rises nor the low volumes of shares being traded.

The money just has to be a carry trade from cheap dollars being driven into stock markets more or less directly by the Fed. For if you inflate equity then you depress the debt burden. For debts, in theory, remain static in nominal terms while equity rises creating wealth.

That is the basic principle of house price inflation too, and we all know how that ended. The trouble is a little thing called fundamentals. House prices, for example, can only rise so far out of line with rentals. Share prices can only rise so far out of line with profits. But these things get forgotten when a bubble is blowing up.

QEII failure?

Perhaps the achilles heel is the QE process itself, and the ability of the Fed to hoodwink the markets. For money printing only works – and it is arguably not working because it is not delivering growth in the US – for a short period before it trips up over itself into a nasty inflationary mess.

Is that not now what we are starting to see with rising oil and commodity prices? Investors are selling the dollar and buying gold and silver. Share prices by comparison are more vulnerable because they are only paper representations of a company’s worth. Real assets have a more direct relationship to the volume of money in circulation than stocks.

Stocks will rise until there are no more buyers and then they have to find a new level. Might that not be when QEII is announced very early next month? A case of buy on the rumor, sell on the announcement? Certainly by then every buyer that can be pulled into the market will be there, leaving only one way to go and that is down.

Ironically that also answers the question about the bond market. For this stock market correction would give bonds a last spike higher, as some delusional fools would still see them as a safe haven. Others would use an accompanying correction in commodities to advantage as a buying opportunity and buy gold and silver.