Your editor nearly fell off the couch while watching CNBC this morning.

There isn’t much on that channel worth watching, but we watch it anyway. Usually while tucking into our three Weetbix®. We try to ignore the blathering hosts and their drone-ish guests by turning the sound down.

Instead we just follow the ticker at the top of the screen… Dow Jones… S&P500… AUDUSD… USDJPY… Gold… Silver… UST10YR… zoiks…

With all our focus on the Aussie banking system over the last couple of days, we’d taken our eyes off the yield on the 10-year US Treasury. What we saw nearly caused the couch-falling incident.

And we could see why Money Morning reader Jack had sent through this email yesterday afternoon:

“In your discussion toward the end of today’s MM, I’m surprised you did not pick up on the 10year & 30year USGovt bond prices falling (thus yields rising) during the time since they announced & implemented QE2.”

We had noticed the rising of the bond yield since early November. It was something that flew in the face of the supposed reason for the money printing – to keep interest rates low.

But what we hadn’t noticed was the price and yield action over the past few days. The chart below explains it all:

fed
Source: Yahoo! Finance

It’s important to know that price action in any financial market is based just as much on what investors think will happen as on what has happened.

So you can argue that leading up to early November when the US Fed announced its money-printing programme, investors were positioning themselves for what they thought the Fed would do.

They thought the Fed would print a certain amount of new money (not actually printing it, but creating it electronically) and therefore bought or sold US Treasuries on that assumption.

When the Fed made its announcement some punters saw this as the time to get out. The price had risen (yield fallen) as far as they thought it could go. What were they to do next? Hold on to an investment yielding less than 3% for the next ten years? Or sell it and lock in the capital gain.

The latter obviously.

Especially if they were in leveraged positions… which they would be. Remember, even retail investors in the US can get 10:1 leverage on government bond. So goodness knows what leverage the institutions can get. That’s because they’re seen as safe investments.

In contrast, in the US, a retail investor can only get 1:1 leverage on stocks. If you know the Fed is going to print a whole bunch of fresh cash to buy up these bonds, why wouldn’t you front-run the Fed and look to profit.

Well, that’s exactly what they did. And now they’re getting out.

Even the prospect of further money-printing may not be enough to draw buyers back. And if it does there would still be a big bunch of sellers trying to cut their losses and get out.

It’s a problem the Fed has created for itself. If you think about it logically it makes sense. Unfortunately, logic is one of the things in short supply at any central bank.

The fact is, the more new money the Fed creates to push down bond yields, the more new money it will need to create in order to push them down the next time. The Fed is creating 600 billion new dollars to lower interest rates.

So far it has only spent about one-sixth the amount – this morning it bought another USD$1.63 billion of US Treasuries. The bond market is becoming desensitised to the Fed’s bond buying programme.

Bond yields will undoubtedly fluctuate, but will it push rates back down to the level the Fed wants? We doubt it.

So what next? That’s where QE3 and QE4 come into play. But the Fed can’t announce it’s going to just buy another $50 billion or $100 billion… that won’t cut it. The market won’t care. It won’t have enough of an impact on the market to attract bond buyers.

If the Fed really believes printing money is the solution to helping the US economy. And if it believes this involves keeping interest rates low the only action it can take is to really ramp things up… one trillion dollars, two trillion dollars… or more likely, just an open-ended buying spree.

But just as bond buyers have become unimpressed with the Fed’s bond buying so soon, can they be relied upon to maintain enthusiasm for an open-ended bond buying programme?

We doubt it. And that’s when it’ll get super exciting. Not only will the Fed become the main buyer for existing debt, but it will become the main buyer for new debt – bidding for bonds direct from the US Treasury.

In other words, skipping the middleman.

The way we see it is that all the elements for an inflationary super-spike are being created right now. The rotation of new money from the Fed to the market to the government is speeding up… then it’ll reach terminal velocity, and the economic ship won’t be able to take it anymore.

There will be so much worthless paper and electronic money flying around the US and global economies that consumer prices will soar and the economy will collapse. What will that mean for commodity prices?

Well, if you want an example of what to expect, look at the price action for bonds. What has happened with the 10-year US Treasury is a perfect example of how inflation doesn’t necessarily increase asset prices… or I should say it doesn’t necessarily keep asset prices high.

It’s all about expectation and anticipation. Bond buyers expected new money to be printed (inflation), so they bought an asset in advance. Now some of the new money has been created the bond buyers have lost interest. They’ve already priced it in.

And bond prices are falling. Yet there’s still more than USD$500 billion of new money waiting to be created at the tap of a button.

Why shouldn’t that happen for other asset prices?

There’s no reason it shouldn’t.

Courtesy  The Daily Reckoning Aus