By Samuel Rae, diaryofacurrencytrader.com

So the big news last week was the Fed announcing it had finally brought its QE programme to an end. The US dollar rallied and many economists are hailing the Fed’s response to an ailing US economy as a resounding success. Equities markets are booming, the property market is buoyant and unemployment hit 6 year lows last month. My opinion however, is not so rosy. I believe that – in undertaking the massive stimulus programme, the US Fed has sewn the seeds of the next big downturn; further, I believe this downturn is not far away.

What’s my logic? Well, injecting capital into an economy is the simple part. Making the decision to slow, and eventually stop, doing so  is a little harder, but still relatively simple. The difficult part is still to come – unwinding. This term will no doubt turn out to be a buzz word of next year, but as yet, very few outlets are (publicly) discussing its implications. So, in light of this, here goes…

So we all know that the Fed has been buying government bonds. Why? Two main reasons. First, because if it buys long term bonds the yield curve of said bonds will fall. Banks for a long time were holding their capital in government bonds rather than lending it out to businesses, and by reducing the long term yield curve the Fed hoped banks would look for more creative ways to invest their cash. Second, through the purchase of these bonds, the Fed could – theoretically, at least – introduce money into the US economy. This all sounds fair – but there is one key component that many people do not realise – the Fed doesn’t buy these bonds from the government directly, it purchases them from so called “member banks”. A number of these member banks make up the shadow banking system – Goldman Sachs, Merrill Lynch, J.P Morgan etc. So, when the Fed buys these bonds, capital is transferred from the Fed to Goldman Sachs. What is Goldman likely to do with this capital? You got it – shift it to the equities markets. Ergo sum – stock markets get a huge injection of capital. I believe a large portion of the current stock market bull run is attributable to this capital reallocation.

So now we are in a situation where the Fed has $4 trillion worth of assets, about three quarters of which it has to unload to get its balance sheet back to pre-QE levels – this is QE unwinding. Who will be the likely buyer of this vast amount of assets? Goldman Sachs, Merrill Lynch, J.P Morgan etc. Obviously these entities wont just buy them outright – the long term yield curve has declined as a result of the initial buying, after all. The Fed will have to incentivise this buying, with the promise of great rates. And here comes the problem – where will the capital come from? Again, you got it – the stock market. The aforementioned entities are not there to maintain stable growth of an economy, we have seen this all too clearly already. They are simply there to achieve the highest possible return on capital. If they can get a better return from the Fed’s bonds than they can from the equities market – they will, regardless of the implications.

So, in short, as the Fed unwinds QE we will likely see a huge amount of capital pulled out of US equities markets… cue panic selling, crash and economic turmoil.

It’s only a matter of time…

Written by Samuel Rae – author of Diary of a Currency Trader (Harriman House 2013)