For the past 17 months asset prices have benefited from the greatest monetary experiment ever conducted. We have all learned that when $1.55T are printed and bond vigilantes fall asleep at the wheel, amazing things can happen.
However, now that there's only $45B and one month left of QE, it's time to start really thinking about what the world looks like when free money isn't dropped from helicopter Ben's printing presses every week. This is a question that we should have been asking all along, but the end of QE always seemed so far away that the market hasn't really had to focus on the issue. This month is the month to start worrying about it though.
My guess is that the result wont be pretty, but I'm still torn as to what the picture will look like. I do know that all eyes should be on interest rates as they will tell the story. Here are what I think the options are:
1) Nothing happens: This seems implausible, but then again little about the last year has been believable. In this case, QE fades away, the economy continues to recover and securities prices are unaffected. Also in this scenario, Ben Bernanke ushers in a new era of world peace when it is realized that all of life's problems can be solved simply by adding an extra zero to everyone's pay check.
2) Interest rates up: The Fed has basically been sitting on top of the long end of the curve by buying so many long dated assets. If the buying goes away, everyone who is short treasuries could finally flex their muscles. In this scenario the curve could steepen to record levels.
3) Interest rates down: The counter argument is that without QE we re-enter a deflationary death spiral in which interest rates go back to 2.5% without any regard for the fiscal conditions of the US government. As the pace of monetary expansion has slowed in the past two months, equities may already be telegraphing the deflationary pressures.
The great thing is that either way (if we get scenario #2 or #3) the likely prescription will be more QE! The US government is facing a $500B funding gap anyways
, so why not use the money to buy those treasuries? Explicit monetization of government debt here we come!