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The End of As Good As It Gets- Professional Edition

The Fed has bought $45 billion of Treasuries in the first two months of QL1.5, including $7.3 billion last week. It’s been good for 80 points on the S&P 500, 650 on the Dow, and a 35 basis point decline in the 10 year yield.

With QL1.5 working as well as it is I don’t know why anyone is speculating that QE2 is a done deal. Perhaps it’s because those betting on it don’t understand the transmission mechanism of monetary policy very well, if at all, and that includes the FOMC members who have proven themselves time and again to have no clue. It’s pretty simple. The Fed implements monetary policy via trades with Primary Dealers. They are the conduit by which the Fed’s cash is created and pumped into the financial system and the economy. The stock market goes up when the Fed pumps cash into Primary Dealer trading accounts, and QL1.5 is accomplishing that quite nicely. And there’s even a hint in recent weeks via the Federal tax receipts that some of that cash may be filtering into the economy (see

The Fed’s purchase program renews itself in the middle of the month. Last month’s goal was $27 billion. The quota for October-November will be announced Tuesday. The Fed’s stated purpose for QL1.5 is to keep its balance sheet level at $2.054 trillion. In order to do that, each month it guesstimates how many Treasuries it will need to buy in order to replace the MBS on its balance sheet that will be prepaid in the next month. It has a black box that tells it how much to guess. As rates fall, refis increase and the prepayment rate of the MBS that contain them also increases.

So it should come as no surprise if the Fed announces on Tuesday that it will buy even more than $27 billion over the next month. One Fed official even said as much. That of course would be bullish for both stocks and bonds, not to mention, to the Fed’s consternation, all manner of commodities, especially oil and gold. At some point, the rise in commodities will corner the Fed. We’re not there yet, but it will be interesting to hear the Fed explain away raging commodity inflation as it begins to show up at the gas pumps and in the grocery stores. They’ve been ignoring it or offhandedly dismissing it until now. Eventually the market will call them on it.

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  1. ter

    Fine article, offered at a critically important moment, when many are expecting this bull to encounter a picador. Recommend you copyright as an “Adlerism” SAHP–Seasonally Adjusted Hocus-Pocus.

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