Tuesday, September 22, 2009

What's the Fed to do?

Tomorrow will be a significant day for the markets. It may mark the first day we hear the Fed's plans to exit the quantitative easing program initiated during the midst of the crisis. This could cause significant pain to the market short-term, but may provide a catalyst for the markets to move higher. As the Fed moves out of the mortgage business (effectively ending its purchases of 10 and 30-year treasuries), the market will need to soak up all the Treasury's liquidity without the U.S. government's assistance. I'm not sure where the heavy lifting will come from, and this may prompt higher yields in longer term treasuries. While this will reduce confidence in the U.S. dollar, it will do wonders for the competitiveness for U.S. exports, and bringing some inflation into the market. Depending on the velocity of the Fed's tightening of the money supply (through reduced treasury purchases), we will see this inflation bring higher commodity and equity prices, as future earnings prospects will accelerate.

On another note, it will be some time before we see the Fed increase the fed funds increase, as the Fed will need to first remove the layers of support that have been thrown over the faltering economy, including the quantitative easing, TARP and TALF programs. Thus, I see a steeper yield curve, a lower U.S. currency (vs. commodities at the very least), and better future prospects for the equities market. Only time will tell - the initial reaction is not necessarily the right one in the market.

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