The main issue the Fed faces in the next few months is what to do with the end of their purchases of mortgage debt. Let it expire and end the biggest portion of their QE policy at the risk of higher mortgage rates or extend and expand it because of worry of higher mortgage rates? In the release of the minutes from the Dec meeting, “all members agreed that no changes to the Committee’s large scale asset purchase programs…were warranted at this meeting” as the economic outlook hadn’t changed much since their Nov meeting. They did say though that they will “continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in the financial markets.” A few members were worried about the wide output gap and wanted “more policy stimulus” especially if growth faltered and mortgage problems arose. One wanted to scale back the asset purchases.
The US Treasury market, Fed and the level of interest rates hold the key to stock market performance in 2010 and the thesis will specifically be put to the test just in the next few months. If the Fed decides to stick to their current plan to end the purchases of MBS/Agency debt by March 31st, yields are going higher with mortgage rates following and stocks are going lower as they’ve already priced in, in my opinion, a healthy rebound in corporate earnings. If the Fed caves in because of the fear of what higher rates will do to a still fragile but improving economy and announces another round of asset purchases, aka more money printing, no matter what the size, the reflation trade will be in full force, the US$ will resume its downward trend and nominal gains in stocks will continue.