Price levels, stock markets, and All That

Anyone who's seen the recent market rally, be it credit, equity, or in the commodity space, must appreciate that they are on the receiving end the Fed's QE bat.

The argument from the Fed is simple: imbue people with inflation expectations, and they will pull demand from the future, stimulating production now: You buy the car today if you know it'll cost more tomorrow, etc.

However, nothing in Fedland is ever simple: while they seek to pull demand, they also can't compromise the treasury market. The US gov is facing record deficits, and huge interest payments under the magic of continuously compounding interest will only exacerbate the economic crisis.

And so we are torn: the real downside for pulling future demand is an exorbitant cost of capital for the US government. Considering the need for stimulus, wars, and entitlement programs, it stands to reason that inflation expectations will be necessarily curbed by government finances. Furthermore, the recent market rally has allowed key players to raise necessary capital to cover their short-term obligations, and so near-term solvency has been established.

Here's a theory on what will happen: the Fed will actually start pulling liquidity from the market, correcting the equity market and giving strength to Treasuries again. The media will blame unemployment, but the wise amongst us realize it's because the money tap will have been turned off - for a moment. Once .gov has filled her coffers with relatively cheap debt, the Fed can QE accordingly to keep the market plodding along, all the while propping up inflation and hence growth expectations.

I would not be surprised at all to see positive Q4 GDP numbers... especially if price levels rise substantially!