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"We have to recognize that QE2, while a possibility, is not necessarily what we want to do given the benefits versus the risks… We are not an island. We affect other countries, they know that and they react to us, and therefore we are affected by our actions as it comes back to us." (Thomas Hoenig, KC Fed Reserve President, 10/12/2010)

Translation? The Federal Reserve is playing a chess game. And only two years into the Great Recession, with the root causes and global imbalances still persisting, do you think the Fed is going to launch its queen?

Goldman (NYSE:GS) and other investment banks, Wall Street’s arbiters, have deemed from their perch that QE2 is mostly priced into the market. While it's insane to think an action - so unprecedented and massive, without apriori statistical analysis or plausible modeling, occurring in an open system with a virtually unlimited variables - can be “priced in”, a short-term trader should withhold skepticism as prices are currently set by supply, demand, and which side of the bed the Fed Chairman wakes up in the morning.

What has been the effect of QE2 since we entered the bizzarro world this summer where down is up, up is down, and bad news drives the stock market up?

The 2-year and 5-year have fallen to record lows (an absurdly low .375% for a 2-year note - from 1% at the beginning of the summer). The 10-year fell 60 basis points from 3.0% on August 1st to below 2.4% currently. This is critically important for the United States government. Interest as a percentage of the Federal Budget hovers around 8%-9%, near the 10% Greece level which sparked the European sovereign debt crisis. For a government that is reliant on unstable short-term debt for its fix (kind of like an addict) and with 60% of government debt to expire within three years (around $8 billion in debt - actually, let me write that out for you: $800,000,000,000 in debt) and 40% within two, the manipulation of interest rates is critical for the United States to keep its doors open. With the weighted average of the US national debt a ridiculously low 1.21%, a percentage point to the uptick costs the Treasury around $100 billion dollars- not to mention the geopolitical and economic instability that would occur when the a bankrupt nation is stuck with an even higher tab.

With that said, the mere threat of QE2 has allowed the Federal Reserve to lower its interest (essentially refinancing its debt) without even having to fire a shot from its last remaining bullets, all the meanwhile preventing a “national” catastrophe such as a weak or even failed auction. The downside, however, can be seen in commodity prices.

Every commodity class has experienced inflation. Oil prices have risen from $70 a barrel in late August to nearly touching $85 dollars recently. Precious metals, like gold, have jumped from $1150 in August to around $1360 currently, and silver from $18 to $23.50. Copper from $3.25/lb to $3.75, Coffee from $170 to $190, and so on and so forth – pick an asset and it has probably risen despite weakening economic data. It is not that commodities are rising on strong demand but that that the dollar is declining vis-à-vis commodities due to higher dollar supply (through QE expectations).

High input costs through commodity inflation has the potential to hurt consumers and threaten the “fragile recovery” (*eye roll*, or whatever crap economy the political establishment can tout as the “Summer of Recovery” ) that we are currently experiencing. Not to mention the political outrage that will caused when people realize $100 dollar oil is caused by thirteen bearded bankers trying to play God with the global economy.

Thus, the Federal Reserves’ goal in the November meeting can be reasonably assumed to be “lower yields, lower commodity prices”. However, there is a difference between the markets. One market is extremely liquid and has multiple, various actors and one market has a few primary dealers and is currently dominated by one entity. Can you guess which one is which?

As ZeroHedge reported, if the Fed continues its current pace of purchases, it will absorb all new net issues of debt for FY 2011 (an estimated $1.15 trillion dollars) and will be the only public owner of long-term T-bills. Goldman Sachs has publicly announced that they believe QE2 will consists of about $1 trillion dollars in new treasury purchases which would cover the FY 2011 budget deficit, which as some speculate, could require the Treasury to issue even more debt than needed to almost reverse fund a $1 trillion QE program. However, since 2008, the Federal Reserve has been issuing 50% more debt than needed to cover the deficit. What does this mean?

This means the Fed could announce a severely underwhelming QE2 number while maintaining low interest rates. Since the market is illiquid, controlled by a few primary dealers (who, incidentally, trade inside information and coordinate policy with the Fed), and still being monetized by the Fed through QE-lite, it is extremely doubtful a small initial QE number could cause a spike in yields. Then, throughout 2011, the Fed could limit the supply of 2011 auctions as this debt has already been issued. In the meanwhile, the small number could quickly evaporate the speculative gains in commodity costs.

My best guess is that the Fed will point to better-than-expected corporate earnings (as corporations are squeezing labor for profits) to reduce its purchases and announce an open-ended $500 billion dollar Quantitative Easing program. The “open-ended” language will be so flexible one could drive a truck through it. It would allow the Fed to opaquely manipulate treasury yields and stealthily monetize US debt while comforting the financial industry with a watchful backstop.

It is the best of all words:

  1. Issue a “careful & bullish” report on the economy used to justify lowering QE expectations priced in to the market,
  2. Announce a small initial purchase that torpedoes speculative gains in commodity prices
  3. Keep purchases open-ended so that it acts as the US Financial Industries Big Brother
  4. Maintain low interest rates and try to relate the bubble

Thus, there is economic incentive for the Fed to have QE2 be "received” poorly by the market (or more absurdly, by the traders sitting on HFT supercomputers who will scan the headline and see a number less than $1 trillion causing a Zombie-like pile-up rush to be the first to dump commodities).

While I am super-bullish commodities, I think the next month offers a good opportunity (better odds I should say?) of a short-term bearish trade on commodites.

Disclosure: No positions

Source: Why QE2 Will Disappoint