The stock market and the commodities markets have so far supported QE2.  Longer-dated bond yields have risen as a result as the extra $600 billion applies only a few percentage points of the allocation into more intermediate term Treasury notes.  This will weaken the dollar and other countries are not very happy with the United States over this.

The move is an interesting one in theory, but if an individual were to pursue this strategy he or she would be laughed out of the park.  The move is rather simple: print up new cash and use the money to buy up shorter-term and intermediate-term Treasuries to keep rates low.  In short, dilute the currency and keep an artificial environment going with interest rates extremely low to near-zero to fight deflation.  The big issue is that printing money is inflationary while buying up Treasuries increases Uncle Sam’s balance sheet with securities that either mature or which will have to be sold (or used as collateral) down the road.

Is this currency manipulation?  The U.S. has been after China to loosen the peg on yuan against the dollar.  So far, China has committed only to a gradual devaluation of the currency into wider free-exchange bands.  That may take too long, and this move to print money to buy up assets may force China to unload currency in that peg.  Even if China holds on to its dollar horde, the impact may be the same.  Where this becomes a conundrum is that China would likely unload Treasury securities along the way and it would likely buy even fewer Treasuries as a percentage of its Central Bank assets ahead.  That would imply that China could keep selling and large portions of the money freshly printed just went to buy up the debt held by China.

The FOMC wants inflation a bit closer to its 2% implied target, far higher than what has been seen.  With the FOMC keeping short-term rates low at near-zero and with the Treasury increasing its balance sheet by buying Treasuries, this forces investors into risk-based assets.  If you can magically get inflation to 2% and short-term and intermediate-term Treasury rates are so low, what does that do to real returns on an inflation-adjusted basis?  Yep, negative real rates of return.

We already saw a TIPS inflation-adjusted security trade at a negative rate of return as investors seek safety yet get upside yield moves down the road if rates rise. As of today, The 5-year T-Note yields a whopping 1.18% and you have to go out to the 10-year T-Note to reach a yield of 2.58%.  That puts investors needing to invest about 7 to 9 years out the maturity schedule just to reach break-even on their real returns. If you consider Federal Income Tax, then investors have to go further than the 10-Year maturity just to reach a real after-tax zero-rate of return.

The move in the ETFs points more to the direction of where investor bets are heading more than it does address the issue over whether the U.S. is a currency manipulator. SPDR Gold Shares (NYSE: GLD) hit a 52-week and all-time high at $139.15, implying that above-$1,400 per ounce mark after fees.  The PowerShares DB Gold Double Long ETN (NYSE: DGP) also hit all-time highs of $43.23 earlier this morning and its gains are nearing a double from the lows of the last year.  A bet against long-dated Treasury maturities has been seen as a winner via the ProShares UltraShort 20+ Year Treasury (NYSE: TBT), which is an ETN that is double-short the 20+ Year Treasury index.  As longer yields are rising, it rose above $36.00 on Tuesday for the first time since August.

The last is the impact on the Direxion Daily Financial Bull 3X Shares (NYSE: FAS), with 300% of the intraday moves of the banks and financials in the Russell 2000.  Shares are still well above the QE2 announcement as a measure on the steepness of the yield curve, but the underlying shares in the index have not at all lived up to the broader market performance of late.

JON C. OGG

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