This is an extended excerpt from the Professional Edition Fed Report Executive Summary.

Note: Pages 4-10 comments correctly updated at 3:55 PM NY time.

The composite liquidity indicator rose sharply last week, driven by a big Fed settlement of MBS purchases. The uptrend in the indicator is accelerating. Over the course of this latest surge, most of the benefit of this increase in liquidity has been targeted at the Treasury market.

As the Primary Dealers try to keep yields as low as possible on behalf of their primary client, the US Government, they are also giving themselves time to distribute their unusually large long positions, most of which were acquired near or above current prices. That run to 2.40 on the 10 year a month ago was an intolerable situation for them at the time. Now that they’ve put themselves in position to work off some of the inventory at better prices, at some point they will want to stand aside from taking on so much Treasury inventory and focus elsewhere. As a result, both bond and stock prices could face crucial inflection points in the weeks ahead. But in the short run, another parabolic buying panic in bonds is under way.

I would expect the liquidity indicator to develop a negative divergence before the stock market tops out ahead of the next major cyclical bear market. So I suspect that the recent stock market malaise is just a matter of the market owners, mostly Primary Dealers, shaking the stock market tree to benefit their Treasury positions, and their biggest client’s absolute necessity of keeping its borrowing costs as low as possible. In weeks such as this one when the government must roll over a huge amount of long term paper, not to mention adding new paper to that pile, the focus will always be on funneling available liquidity toward that purpose, thus keeping the government’s borrowing costs low. The market’s managers are off to a strong start this week as the first auction of intermediate term paper gets under way on Tuesday.

The Treasury rally is also partly due to the $50 billion in paydowns that came back to holders of short term Treasury paper last Thursday. Many of those holders were Primary Dealers. They took the cash and used it to squeeze the Treasury shorts while other investors who were flush with this cash simply panicked into buying longer duration paper because there weren’t $50 billion of bills available to absorb the cash.

This is a short term situation that should burn itself out within a few days. After this, the next Treasury paydown won’t be until mid June. There will be lots of new supply and not quite as much cash until then, so I do not expect this move in Treasuries to result in yields dropping significantly below the levels reached by last September, if at all.

In those alternate weeks where Treasury supply is confined to short term bills, the dealers usually find reasons to support stocks while they let yields drift up a bit. That process could start once this week’s auctions are out of the way on Thursday.

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