QE2: What To Expect From Wall Street

Treasury supply was heavy this week, but payment for virtually all of it is not due until Monday. The Fed took care of that little problem when it announced on Wednesday that it will buy $105 billion of treasuries over the next four weeks, beginning with $31.5-$42.5 billion between this Friday and next Friday. After Monday, there will be no new Treasury supply until a week from Thursday. The Fed will be buying every day between now and then. A flood of cash will be sloshing around the market with nowhere to go. It will make for an interesting week.

With all that cash coming every day against no new Treasury supply, yields should be suppressed and the stock market could take off into the stratosphere, with the result being that Wall Street would declare Bernanke a genius and a saint. The Street will proclaim yet again that the market is a discounting mechanism and that economic recovery is under way, with much higher corporate profits around the corner. The girls on CNBC will be in their best party dresses. The guys will grow horns, and not on their foreheads.

In reality it will be a simple matter of the Fed cornering the market in Treasuries, and at the same time forcing billions and billions in cash into the coffers of investors. They will do what they do and bid stuff up. The markets will be pressured higher by the simple fact of too much cash and not enough paper to absorb it. But the pundits will make up excuses for why the market is rising. The false facades will be filled and propped up and nicely painted, and everyone will believe it’s real until the Fed, after a time, under pressure from soaring commodity prices, will be forced to stop pumping. Then everything will collapse. But for the next couple of months, Treasury yields should be lower, commodities prices probably much higher as the dollar collapses, and stock prices should head higher.

Final monthly budget data from the Treasury showed a 7.9% gain in tax receipts which was a little slower than the prior two months.

Now that Ben has tripled the amount of QE to over $100 billion a month from $32 billion last month under QL1.5 (Quantitative levelling 1.5), I would expect additional economic strengthening and even higher tax receipts. It certainly won’t be triple the recent rate of improvement because the rapid inflation of the cost side of the profit equation will exert an increasing drag on profits and retard any impetus for new hiring. But for the next month or two we should see further strength in government tax revenues, probably resulting in even greater reductions of Treasury supply than the TBAC forecast. That will exacerbate the impact of QE2 on the stock, bond, and commodity markets.

There is an alternative scenario which I consider unlikely but worthy of mention nevertheless. The dealers could decide to use the cash from the Fed to simply de-lever—pay off debt and send the money into purgatory until some time in the future that they feel randy enough to re-leverage their balance sheets. In the event that they choose that path, a black hole will open up in the market and the economy. It happened in Japan; it could happen here. Next week should give us some cues as to whether this is at all likely here.

I review the Treasury side of the equation in this update, and follow later this weekend with the Fed, foreign central bank, banking, and fund flows. It’s a fascinating story, farce in the beginning, but in the end a classic Greek tragedy.

This is an excerpt from the Wall Street Examiner Professional Edition Fed and Treasury update. The full report includes charts, tables, and in-depth analysis reported weekly and as developments warrant. Stay up to date with the machinations of the Fed, Treasury, and foreign central banks in the US market, along with regular updates of the US housing market. Try it risk free for 30 days.

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