QE

The Fed announced plans to buy up $300B in Treasury bonds. Now to be clear, the Fed is not buying up existing holdings of Treasuries, but is instead planning to be a buyer in imminent debt issuances by the U.S. Government. This means that the Fed still has one arrow left in its quiver.

I am grappling with the timing of the Fed's move. The stock market sustained a rally until the news of the Fed's plans hit the net. Investors were starting to feel the bottom. Now, the uncertainty that has dogged the market for over three quarters is back.

Why now? A strong dollar in the short run is still a good thing. It keeps energy prices low and provides a stable backbone to the world economy. A strong dollar maintains the sense of safety inherent in Treasury bills and supports confidence in the U.S. as a government and as an economy.

According to form, QE is implemented when a zero interest rate regime fails to stimulate economic activity. The central bank then needs to scare people out of currency and into assets, and the best way to do that is to weaken the currency. So, if the market is rallying, which signifies a return to risk-taking, then there is no need to scare people into buying assets. Contrariwise, a rational investor (are there any rational investors left?) would interpret QE in the midst of a rally as a signal that the economy is still too dangerous for play.

Furthermore, for the stimulus to be effective, stuff needs to be purchased. With a weaker currency, the stimulus money will buy less. And who believes that the difference will be made up by increased exports?

"Hello, my name is liquidity trap."

Unless investors perceive the Fed's move as immaterial, or a signal that the worst is behind us (meaning that the economy is leveled out and we can move on to inflating our debt away), then the market rally should continue. If the Fed's move is interpreted as a move to correct even greater underlying problems (e.g., a fear that there won't be enough buyers of U.S. debt; i.e., China; cf. Italy), then investors will return to the sidelines, content to lose a little against inflation instead of losing a lot against a still-retreating market. Where does that leave us? With tiptoes tickling the iron jaws of a liquidity trap.

Last Step Before QE

What more can the Fed do? Quantitative easing is next, I guess. As if the Fed's balance sheet didn't look bad enough. The only good news about the Fed rate cut is the weakening of the dollar. This should bolster commodities a bit, plus it will quiet the deflationary spiral panic monkeys.

See:
http://www.thebigmoney.com/articles/explainer/2008/12/16/bernanke-s-blowout

What can't the Fed do? Fix the economy. The problems are now systemic. The spread between the corporate bond (Baa) and 10-year Treasuries is around 6 percentage points (http://www.treas.gov/offices/economic-policy/macroecon/monthly_economic_data.pdf), which means the perception that corporations will fail is extremely high. Think of it another way, corporate bonds are now giving much greater returns than shares of equity. I thought several months ago that there might be a bit of a bond bubble. Looks like it has arrived. The good thing about a bond bubble is that it can only burst with widespread corporate defaults. If that happens, get a gun because chaos will reign when unemployment hits 20% or so.