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Primary Dealers and Their Biggest Client Off The Hook For Now, What Next?

The composite liquidity indicator edged higher last week, continuing a slow but steady uptrend. In February and March, the indicator had accelerated upward away from its 39 week moving average. That acceleration has slowed, but the indicator continues to advance.

With somewhat less abundant liquidity, the government and Primary Dealers have targeted that liquidity for the Treasury market, trying to keep yields as low as possible on behalf of their primary client, the US Government, while trying to give 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 look elsewhere. As a result, both bond and stock prices could face crucial inflection points in the weeks ahead.

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 strongly suspect that the recent stock market malaise is just a matter of the market owners 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 last week 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. Last week the market’s managers were quite successful at that, pushing Treasury yields down sharply through the week.

In those alternate weeks where Treasury supply is confined to short term bills, like this week, the dealers usually find reasons to support stocks while they let yields drift up a bit. That didn’t quite happen on Monday because the market suffered a bit under the weight of settling $23 billion in net new Treasury paper sold last week.

Now that that’s out of the way, the dealers can focus on the $50 billion windfall that’s coming on Thursday.

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