One of the great debates that has been raging in the financial markets relates to the “quantitative easing” (QE) policy of the US Federal Reserve. In a very basic sense, QE is the policy of the Federal Reserve in which it buys back the debt (bonds) of the US government in the open market. By buying the bonds, the intent is to raise bond prices which helps to push down interest rates. At the same time, these purchases put more cash into the banking system. In turn this is supposed to make mortgages more affordable and help the economy to recover. In the current recession, England's central bank was the first to adopt the QE among the G7 while Japan used it earlier this decade to get its banking system functioning.

After keeping the markets guessing as to whether or not they would adopt the QE policy, the Fed made its move by announcing its intention to purchase Treasury bonds in the open market. The large one day rise (highlighted below) turned out to be a one day wonder. Since the announcement by the Fed, Treasury bond prices have gone into a tailspin. This year's performance for US treasury bonds has contributed to the poorest bond market since the late 1970s. Consequently, we are already seeing some early signs of a moderation in mortgage refinancing activity in the US.

Click for full-sized image.

One reason for the puzzling reaction of the bond market has to do with the fact that China is the largest foreign holder of US Treasury bonds with holdings of about $760 billion. The Chinese are worried that the QE policy will unleash inflationary pressures which would put a substantial dent in the value of their bond holdings. In order to reassure Chinese monetary authorities, US Treasury Secretary Timothy Geithner made a trip to China this week to try to allay Chinese fears so that they will continue to purchase the enormous supply of Treasury bonds the US issues each week to help finance its immense budget deficit – not to mention the bailouts for banks and car companies. From its perspective, China has let it be known that US Treasury bonds are not the only alternative for its massive foreign exchange reserves. The concern amongst the market is that China might start to divert some of its foreign exchange reserves from purchasing US Treasuries towards gold and industrial commodities. Given all of the enormous budget deficits that are expected from the US, this is not a happy scenario. After all , a borrower that starts to lose the confidence of its largest lender is never in an enviable position. Chinese attitudes towards their enormous investment in US Treasuries can be summed up by the following exchange Geithner had with a student at Peking University: When he was asked if China's investment's in the US were safe, Geithner answered that they were. In turn, the audience broke into laughter. However, we should balance this episode by acknowledging that China does not want to see the US economy go off the rails and needs to try to balance its own worries with seeing to it that interest rates are held in check from wild swings.

Another reason for the decline in bond prices emanates from investor fear of inflation. The fear is that all of the enormous monetary reserves being put into the economy will result in an overheated economy with rising inflation. Needless to say, none of this has helped the US dollar – which has also been falling steadily. This in turn has led investors to pile into commodities and caused rather large movements in the Canadian dollar and other world currencies. Thus, we can see that US attempts at stimulating the American economy are being met with some serious obstacles by global financial markets – chiefly China. Recall, that immediately after becoming the US Secretary of State, Hillary Clinton made her first foreign stop in Beijing. The US needs China to continue to write the cheque and keep buying US debt and China needs the US to keep buying its goods.

Ajbinder (AJ) Sull is president and chief investment officer at Pacifica Partners - Capital Management in Surrey, B.C