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.
PIMCO's Bill Gross believes there will be a need for Stimulus II, shifting the focus from backstopping financial institutions to kickstarting job creation. In this interview for Time Magazine, the Managing Director for the world's largest Bond firm says this:
The first half will be dominated by government stimulus and by inventory accumulation or a lack of [inventory] liquidation among businesses. I expect nothing from consumer [spending] and nothing really from housing or really any of the standard cyclical leading sectors. It's hard to put a number on GDP growth rates, but let's say 4% in the first half and then 2% in the second half, which would basically call for some additional help.
By March we will know if Bernanke/Geithner did enough and if there is enough residual from Stimulus I to effect the national economy in any real way. If stocks retrace significantly and if Interest Rates increase (I think they will), then fears of a double-dip recession will generate the need for a second stimulus package. If we are being set up for Stimulus II, the $2 trillion dollar question is: How will we finance the deficit without more QE?