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When the Fed announced that it wanted to exit QE, the "genie was let out" in terms of long-term interest rates.

Can the Fed put that genie back in the bottle? Can it do so without inflating asset bubbles? What does it mean for the bond and stock markets?

The Inexorable Math Of Higher Long-Term Interest Rates

The Fed has been manipulating long-term interest rates downward in unprecedented fashion. The Fed has purchased, and now owns, 49% of all US Treasury bonds with maturities of between 10 and 15 years.

As I argued recently, once the Fed announced that it was looking to end its manipulation of long-term interest rates, a rooster could not crow more clearly: Long-term interest rates are going to rise!

From the point of view of any prospective or current holder of 10Y Treasuries, the math of higher long-term interest rates is inexorable. Assuming the return of relatively normal economic conditions any time within the next three years, including inflation of 2.0%-3.0%, the yield on a 10Y Treasury note will move to the 4.5%-5.5% range. For current holders and/or purchasers of the 10Y Treasury, this implies a capital loss in the order of 12%-20%+. The yield differential between the 10Y which is currently yielding 2.66% and safe short-term alternatives yielding 0.5%-1.0%, simply does not compensate for the prospective capital loss and/or the opportunity cost of holding 10Y Treasury notes - again, even if you assume interest rate normalization will take another three years.

Therefore, if an investor believes that the Fed will end QE at any time during the next three years, new investment in long-term Treasury bonds and most other long-term bonds makes absolutely no sense. Furthermore, anybody that currently owns long-term bonds should seriously consider selling them into strength (taking into account tax and various other individual considerations, of course).

Smart investors are not going to wait for the Fed to announce the end of QE to get out of long-term bonds. This pre-emptive exit from long-term bonds will drive LT interest rates to normal levels well before the Fed has exited QE.

The Greater Fool Strategy Collapsing On Itself

Given all of the above, one must seriously question why anybody would have owned long-term bonds at any time in the past few years. With the exception of a small fringe of investors that believe in a deflationary future for the US (a highly implausible thesis, in my opinion), the answer is that such individuals were playing a version of the game of the greater fool.

Application of the "greater fool" strategy is clearly exemplified by Bill Gross, the largest bond fund manager in the world. Up until two years ago Gross was trumpeting his opinion that long-term treasury bonds were fundamentally overvalued, rhetorically asking: "Who will buy Treasuries if the Fed Doesn't." At first, Gross put his money where his fundamental inclinations led him. However, contrary to his expectations, treasury yields dropped and the performance of his PIMCO funds tanked. So, Gross next decided that the best investment strategy was to simply go along for the ride and try to exploit the Fed's policy to PIMCO's advantage. Therefore, Gross executed a 180 degree U-turn and advocated purchasing Treasury bonds - that were obviously overvalued by his own reckoning - as long as the Fed continued to support the market. Gross evidently based his investment "strategy" on the assumption that he would be able to sell those bonds to some other sucker right before the Fed pulled the plug on QE.

Things have not quite worked out as Mr. Gross had planned, and his shareholders are now holding the bag. Even after sustaining major losses after the first hints of "tapering" Gross doubled down on the "greater fool" strategy, announcing to the world on twitter that, "We're sticking with bonds as long as the Fed does." Note that Mr. Gross has not even bothered to pretend that Treasury bonds actually represent good value from a fundamental point of view; Mr. Gross merely argues that clients should invest in PIMCO funds that are stuffed with ridiculously overvalued Treasury bonds because Mr. Gross will presumably be able to skillfully schlep them off to some greater fool before the Fed pulls the plug. I will allow readers to judge the soundness of this investment strategy.

The point is this: As long as investors could plausibly believe that QE would be of indefinite duration, they could plausibly gamble that they might be able to harvest the differential between short and long-term interest rates for some period of time and pull out when it looked like the Fed was going to pull its support for the market.

Today, this "greater fool tactic" is no longer a viable strategy. The genie is out of the bottle. The Fed has already announced that it wants to exit QE as soon as the economy has normalized. Therefore, any progressive indications of economic normalization should send 10Y bond yields soaring in the direction of their ultimate destination, which probably is the 4.5%-5.5% range.

Implications for Stocks

The negative implications of all of the above for long-duration fixed income instruments such as (NYSEARCA:TLT) and (NYSEARCA:LQD) should be clear. The implications for major stock indices or index ETFs such as SPDR S&P 500 (NYSEARCA:SPY), SPDR Dow Jones Industrial Average (NYSEARCA:DIA) or Powershares QQQ (NASDAQ:QQQ) are far more ambiguous. As I argued in my most recent article, stocks have decoupled from bond yields long ago.

In my view, a significant delay of tapering is not necessarily bullish for stocks, because that sort of delay could only be caused by reasonably founded fears of a weak and fragile economy. By contrast, a stronger economy on more solid footing heralds the end of QE.

Most people believe that the end of QE would be bad news for stocks. I believe that the opposite is more likely true. The end of QE will likely coincide with stronger economic prospects, plummeting economy-wide risk aversion and collapsing liquidity preference. In the context of extremely high levels of excess liquidity in the financial system, this is a perfect formula for the ignition of inflation - particularly in asset price markets.

In future articles, I will elaborate more on the prospect of the end of QE coinciding with the formation of a bubble in the stock market. In the meantime, those who would like to better understand my thesis regarding the relationship between asset price bubbles, excess liquidity and declining liquidity preference should consult the following articles: "Why A Stock Market Bubble Is Forming Right Now," "Beware Long-Term Damage From Stock Market Bubble Forming Now," and "A Bubble Continues To Form In The Stock Market."

Conclusion

It is highly unlikely that the Fed can put the long-term interest rate genie back into the bottle. If you factor in the end of QE any time within the next three years, the math is inexorable and the rise of long-term interest rates becomes almost inevitable.

With respect to stocks, it is my view that equities may not be able to muster another large up-leg in the current rally while uncertainty about tapering persists. That is because no-taper implies slow economic growth, high risk of recession and unfavorable corporate earnings growth prospects. On the other hand, yes-taper will be associated with actual or prospective instability in the bond market which may very well spill over into equities while the adjustment takes place. Taper may place the market in a sort of "dammed if you do, dammed if you don't" sort of purgatory.

It may not be until the uncertainty about tapering is actually gone and the end of QE is clearly visible that stocks will get the "green light" for the next leg in the stock market rally.

In sum: I am cautious about stocks in the short-term as long as the uncertainty over tapering and the end of QE persists. In the intermediate term, I am constructive towards equities. Please note that my constructive intermediate-term stance is not derived from great exuberance on my part about the future of long-term fundamentals such as earnings growth; it is derived mostly from my forecast of the likely consequences of the unprecedented levels of excess liquidity that is currently floating around in the financial system coupled with the prospects for a relatively rapid cyclical normalization of liquidity preferences.

The long term is a different story: A price will be paid for monetary excess. There is no free lunch.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.