Quantative Easing to Infinity and Beyond?

Last week, to the total dismay of many in the market the Federal Reserve "surprised" the market by not initiating a reduction in their great stimulus program know as Quantitative Easing (QE). Among the reasons for the market to presume that a "taper" would begin was that in their Federal Open Market Committee (FOMC) minutes from previous meetings they mentioned that they had discussed the idea of a taper.

The market's reaction to this suggestion that they might start to taper QE was to drive mortgage rates from approximately 3.5% to 4.5%-still low-but a large jump relatively speaking, and to make the 30 year treasury trade off quite sharply.

Now to taper or not to taper was a 50/50 bet from the outset. The economic news in the US is constructive, but certainly not creating any stresses in the system. Unemployment is down, but I would draw your attention to the fact that many people seemed to have stopped seeking employment and so fall out of the pool, plus temporary as opposed to permanent employment growth seems to be the flavour of the recovery.

Add to this an almost pathological fear of deflation by the current Bernanke Fed, which will most likely be continued by a Yellen Fed, and I believe the market seriously got ahead of itself and fell into that most dangerous of traps-believing your own hopes to be facts.

So is the long end of the treasury curve artificially low?  A resounding Yes!
Is there the potential that if the Fed were to continue to purchase the long end in their QE quest that they would be creating serious inflationary pressures?  Again a resounding Yes!

But did I believe that the economic recovery has shown any real inherent strength strong enough to warrant essentially putting a break on economic potential? A resounding No!

Do I believe the inflationary pressures are such in the US that the Fed has no choice but to start to taper QE?  You guessed it.  Another resounding No!

At some time the Fed will start to taper.  There is no way that they can continue ad infinitum in their QE washing machine.  But before they start they must coordinate with the Treasury.  In order to help stimulate the economy which is run by two ends of the yield curve- Fed Funds and 30 year Treasury yields, the Fed instituted a "twist" which essentially extended the maturity of the Fed's portfolio thus driving down yields at the long end while Fed Funds have been held excessively low in the front end.

In this case the artificially low yields in the long end must be kept somewhat low, again through artificial means.  The Fed has to get the Treasury to agree to stop issuing long dated debt.  The Fed will stop it's purchases in the long end, moving down the yields curve thus keeping the front end low and allowing/forcing all the index driven investors to purchase long dated securities from the Fed's balance sheet.

Once this reverse "twist" has taken place, the Fed can start to taper it's purchases of the front end of the curve and thereby ease the transition into higher yields without panicking the market or crushing the recovery.

I know, the question is why did all those prop traders really think the Fed would taper?  Why did they make blatantly 50/50 bets?  Believing your own rhetoric is truly dangerous!