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Financial Markets Know QE2 Is “Transitory" - What's Next?

Stock-Markets / Financial Markets 2011 Jun 08, 2011 - 02:00 PM GMT

By: PhilStockWorld

Stock-Markets

Best Financial Markets Analysis ArticleHere are some highlights from the latest Wall Street Examiner's Professional Edition. Lee Adler's perspective on the stock market is extremely insightful as he tracks factors we don't often consider well enough in anticipating how the markets are going to move. Unfortunately, the stock market is largely at the mercy of the money flows between the Fed, the Treasury, Primary Dealers, foreign central banks, the banking system, and the markets. Lee closely follows these money flows and explains how they are likely to affect the markets.


Courtesy of Lee Adler at Wall Street Examiner

Fed and Treasury Update

Virtually all key liquidity indicators are negative as the markets hurtle toward the end of QE in a little over 3 weeks. Large domestic bank trading accounts, bank purchases of Treasuries and Agencies, and foreign central bank purchases of Treasuries and Agencies are all bearish. The indicator showing net cash flowing from money funds into the banking system is on the cusp of turning bearish.

These patterns continue to suggest that the market will be vulnerable to an even bigger decline than the one already under way once quantitative easing ends. The fact that there’s been some front running of the end of QE, and the fact that most people “know” that ending QE will be bearish, are not reasons to take a contrary stance and believe that the market won’t decline. Unless the money flows we are seeing now reverse, and I see no reason why they should, then the stock market should head lower. Liquidation of stocks may boost Treasuries for a while, but I expect that effect to be, in the immortal words of our dear leader, Fearless Ben, “transitory.”

Once the disaster I expect begins to unfold, Ben will start meddling in the market again. Primary Dealers have been buying MBS hand over fist, so my guess would be that they’re looking to unload it on the Fed in the not too distant future. They either know something or intend to strap this stuff to their belts and threaten to blow themselves up if the Fed doesn’t buy it from them.

(5/14/11) The new POMO schedule is slightly reduced, running at about $22 billion a week through June 9. They’ll need to continue at roughly that rate through the end of June to complete the program. That’s when we’ll enter a brave new world. The markets need these cash pumps just to give the appearance of stability. Their absence will allow the markets’ structural instability to show itself. Instead of being delicately balanced on streams of POMO applied at just the right times, they should just topple over. But first we have 6 more weeks of the balancing act.

On the other hand, the debt ceiling issue looms, and I don’t presume to know how that will play out. It’s a contaminating factor insofar as making any judgment about the influence of reduced POMO. That needs to be resolved so that we can get back to the business of analyzing this mess in a more “pristine” environment.

Primary Dealers are handing over their long term Treasury paper to the Fed as fast as the Fed will take it, and interestingly the dealers are not replacing it. PD inventory of Treasuries is crashing. This looks like distribution. They are piling up cash at a breakneck pace. But to what end? Are they preparing for the apocalypse come the end of June, or are they preparing to buy massive amounts of Treasury paper once the Fed leaves the market. The answer to that is a no brainer, but The Street wants us to believe otherwise.

Wall Street keeps telling us that there will be plenty of buyers for Treasuries once the Fed stops POMO. All the evidence that I now see points in exactly the opposite direction. Not only are the PDs treating Treasury paper like last week’s garbage, banks in general are also dumping the stuff. Only foreign central banks have been good public servants picking up tons of the stuff in recent weeks, but even that appears to have stopped. If they go on strike, it will be a catastrophe for the market.

We might muddle through the next 6 weeks while the POMO still flows, or we might not. The front running seems to have already begun and even with plenty of POMO and a big Treasury paydown on Thursday adding even more cash to the market, last week’s teeter totter markets suggest creeping instability. The market may look ok at times when Treasury supply is light like from Tuesday on this week, but when supply is heavy, in particular at the end of May and in mid June, the problems should be more evident.

Interestingly, over the past 10 days, the CME reduced margin requirements on first, stock index futures, then Treasury futures. Again, I don’t think that this was simply the exchanges acting on their own, and I do think there’s a message in these actions. The Fed wants commodity prices lower and stock and bond prices higher, and it will pull the strings to try anything to make that happen. In the end, without QE, the manipulation cannot succeed. Therefore, I think we will see a return of a modified QE in the not too distant future. Look for it to include MBS again. The Primary Dealers have been accumulating that crap hand over fist over the past 2 months.

Meanwhile, we have already seen much of what I was discussing with you back in January and February come to pass.

There was a Treasury paydown last Thursday and another of approximately $9 billion one will hit this Thursday. There’s a big slate of note and bond auctions this week and the government has done miraculously well at pushing yields down. That has come at the expense of the stock market. I’ve always felt that keeping Treasury yields down is Job One for the Fed and Treasury, and if that means they have to sacrifice the stock market, they will. Clearly POMO alone is not enough to do the job with FCBs and the commercial banks on strike at the Treasury auctions.

The current monthly POMO schedule ends on Thursday. The Fed will post the final schedule on Friday at 2 PM. Apparently there will not be an operation on Friday.

As of next Thursday, including MBS paydown replacements, the Fed would need to buy another $68 billion in Treasuries to meet its balance sheet goal of $2.654 trillion by the end of the QE2 buy program. That averages about $24-25 billion per week, which is a slightly higher pace than the past month.

After that, they’ll go cold turkey, buying only enough to replace the MBS paydowns and GSE expirations. That should only be around $10-15 billion per month. While the market’s reaction may not be immediate, I expect it to be profound, with losses primarily hitting stocks as the government’s manipulators and dealer henchmen attempt to use liquidation of equities to support the Treasury market. I’m not sure that will work for long. Treasuries should begin to weaken before too long. We’ll have to watch the technicals closely.

****

On the Primary Dealers, Lee had this to say "the idea that the biggest of them go day in and day out without trading losses strikes me as fiction. If true, the rest of them are a bunch of idiots who are all losing their shirts. What’s the most likely scenario? Let’s just say there’s probably a whole lot of fudgin’ goin’ on."

Primary Dealers’ fixed income holdings have been rising, mostly due to their buying mortgage backed securities (MBS) along with some longer term Treasuries. Given that the PDs are on a MBS buying binge, what are the odds that the next round of QE will involve the Fed stepping in and taking MBS off their hands?

While the non fixed income trading accounts of the large domestic banks rose in the week ended May 25, the 4 week average has been falling. (Primary Dealers and "big banks" are not synonymous, but do overlap. Some PDs are not owned by large banks, and some are owned by foreign banks. Some large domestic banks don’t own PD’s. However, the action in the big bank's trading accounts taken as a whole is mostly driven by the PDs.)

Lee's chart below suggests that the large banks' non fixed income trading assets and the S&P move largely in tandem.


[correction: date on the should be 5/25]

Phil

www.philstockworld.com

Philip R. Davis is a founder of Phil's Stock World (www.philstockworld.com), a stock and options trading site that teaches the art of options trading to newcomers and devises advanced strategies for expert traders. Mr. Davis is a serial entrepreneur, having founded software company Accu-Title, a real estate title insurance software solution, and is also the President of the Delphi Consulting Corp., an M&A consulting firm that helps large and small companies obtain funding and close deals. He was also the founder of Accu-Search, a property data corporation that was sold to DataTrace in 2004 and Personality Plus, a precursor to eHarmony.com. Phil was a former editor of a UMass/Amherst humor magazine and it shows in his writing -- which is filled with colorful commentary along with very specific ideas on stock option purchases (Phil rarely holds actual stocks). Visit: Phil's Stock World (www.philstockworld.com)

© 2011 Copyright  PhilStockWorld - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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