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Liquidity Tide Continues To Rise As Fed Falls Behind The Inflation Curve

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

The composite liquidity indicator rose slightly last week, on a mixed performance of its components. The uptrend in the indicator has continued at a steady pace since it broke out in March. Over the course of this latest surge, most of the cash has been targeted at the Treasury market but in the past week, stocks have seen renewed interest. As Treasury supply goes through its seasonal increase, the pace of the advances in both markets should materially slow, but until the forces of liquidity at least level out, both markets are likely to remain buoyant. Just how buoyant may largely depend on two factors.

First, the Fed will have to decide how to extend its bond purchases in June when the MBS program expires. It must engage in some form of program in order to offset the natural shrinkage of its balance sheet from maturities of Treasuries and GSE paper, and from MBS paydowns. If it simply extends the current program, that will suggest a continuation of modest and irregular advances in stock prices, coupled with a rangebound bond market. The Fed however, may decide to expand the program, buy MBS outright, or buy Treasuries or GSE paper outright. Depending on the amounts, such programs could have more bullish impacts under ideal conditions where commodities cooperate.

That’s not likely. The signs of resurgence in commodities make any expansion of the Fed’s bond buying problematic. The stronger commodities are, the more the Fed’s hands will be tied. I believe that the Fed is already behind the curve due to its focus on lagging and artificially understated measures of core inflation. This problem will at some point hit the market with an “unexpected” upside CPI surprise. If the economic data is reasonably firm, commodity prices are rising, and core inflation measures start to catch up with reality, that’s when the markets will need to face the fact that the central bank gravy train must end.

My sense is that this will happen within 6-12 months. We need to be alert for the underlying signs, and for noises out of the Fed to that effect. As an increasing number of Fedheads start to wring their hands about inflation, and Bernanke’s ventriloquist dummy, Jon Hilsenrath, start to write stories about it in the Wall Street Journal, that’s when we’ll know that the times, they are a changin’.

The longer term direction of the liquidity composite indicator would suggest that the stock market should continue to have a bullish tilt, while Treasuries, which are over-owned and still long term overbought, may get hammered intermittently in spite of the desire of the US Government, the Fed, and the dealers to suppress yields. We will have to rely on the technical signals in both markets, as reported in the Professional Edition Daily Market Updates and weekly Treasury updates to tell the story of whether the liquidity tide is flowing into, or out of those markets.

This report shows the charts of the 7 key components of the composite liquidity that drives the markets, and more than a dozen other charts and tables with clear, concise explanations of those forces that drive and influence markets and policy maker responses. If we are to grasp what the future may hold, we must first have a clear understanding of the present.

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