The Real Reason Markets Are Rallying – and Why it Doesn’t Change a Thing

Over the last week, the major market indices are all up.

If you’ve watched the mainstream financial media, you’d think this uptick were cause for celebration. You’d think the eight-year-old bull market is about to shift into another gear.

Thanks to my proprietary LAMPP indicator, we know that shift isn’t likely.

Over the past few weeks, we’re talked about how the Fed drives the long-term trend of liquidity.

But what influences the Short-Term Indicator, the one that has been sitting on yellow and inching closer and closer to red?

Today, I want to take a deep dive into the short-term components of the LAMPP so that you can understand exactly what’s going to push us from yellow to red.

Here’s what you need to know…

How the Treasury Impacts the Short-Term LAMPP

The biggest component in the short-term LAMPP indicator is the US Treasury.

And right now, the Treasury is about to become as big a player as it ever has or ever will be. This will have a huge impact on your investments in the weeks and months ahead, so it’s important for you to understand it.

Here’s the deal…

The three-month debt ceiling deal means that the Treasury can resume borrowing without restrictions. This increase is needed to repay internal funds that the Treasury has raided since the debt ceiling was imposed back in March.

Additional borrowing will also be needed to return Treasury cash to the level recommended by the Treasury Borrowing Advisory Committee (or TBAC, that group of big time Wall Streeters that tells the Treasury how much debt it will need to sell), which is $500 billion.

That’s an outrageous amount of money, and I doubt that the Treasury would try to raise all of that over and above restoring cash to a normal level and repaying internally borrowed funds in the next three months. It would destabilize the markets.

But it will still need to borrow a substantial amount of money.

There hasn’t been a material increase in the Treasury’s borrowing schedule yet, but it’s coming. The TBAC estimate calls for $501 billion in new supply in the fourth quarter, virtually all in November and December, and the Treasury almost always follows the TBAC script.

If the Treasury follows through this time, it could prove to be a calamity for the markets. The TBAC even warned as much in its August quarterly report to the Treasury.

While Treasury supply will increase, the trend of demand for Treasuries is going the other way. Falling demand in the face of increasing supply is a recipe for a bear market in bonds. Bond yields will rise. That will put pressure on stocks as well.

But this past week, the opposite has been happening…

Putting the Current Rally into Focus

On Thursdays and Fridays, the Treasury issues $32 billion in net new Treasury bills, notes, and bonds. That simply means that new issuance totals $32 billion more than the amount of bills notes and bonds that matured on those days. Existing holders of the maturing paper typically roll it over. In other words, when their paper matures, they buy a similar amount of bills, notes, and bonds, to replace it.

Dealers and other market participants will also need to buy the $32 billion in new debt that the government is selling to fund its operations for the rest of September.

And that money has to come from somewhere.

Buyers can borrow some of it into existence via margin borrowing. In some cases they’ll sell other investments, including other Treasury holdings, other bonds, or even equities to raise the cash they need to complete their purchases of new Treasuries.

This is how large amounts of new Treasury supply can impact stocks. Some buyers of the Treasuries will need to sell stocks in order to pay for their Treasury purchases.

Lately there hasn’t been much new supply to pressure prices. Nobody has needed to sell anything.

That was especially true last week when the buyers didn’t need to absorb $32 billion in net new supply on Thursday and Friday.

Two weeks ago, the Treasury issued a couple of very short-term bills, called Cash Management Bills (CMBs), for terms of one week, to raise $45 billion to carry the government until September 15. On this date, quarterly taxes come in from those who pay corporate and individual income taxes. If you own a business as a sole proprietor or have done any gig work, you know all about that.

Every quarter, the Federal government gets that little tax windfall that gives it a little extra cash. Then it uses that windfall to briefly pay down expiring paper. In this case, it’s the $45 billion in CMBs.

The holders of those CMBs get cash back.

So the dealers and the other buyers of the new Treasury issuance didn’t need to raise the cash by the new supply issued on September 15. They already had the cash from the $45 billion in CMBs that expired simultaneously.

So not only will the $32 billion in new paper get absorbed, there will still be $13 billion left over with nowhere to go.

When cash is lying around, mischief will be made. We’ve already seen some of that mischief with stock prices surging this week. And the money from the Treasury won’t even hit dealer and other investor accounts until Friday. So after the dust settles on the new issuance, there may still be some extra cash lying around on Friday. I’d be mildly surprised if the stock market doesn’t end the week at or near a new high.

But what about next week and the rest of September?

According to TBAC, over the last two weeks of the month, the Treasury would need to sell $34 billion in new money.

That should worry us, right?

Not exactly…

This Is Where the Fed Comes In

This is where the Fed enters the picture.

Every month, it buys mortgage-backed securities (MBS) from the Primary Dealers. It settles those purchases in the third week of the month. This month, the settlements started on September 13 and will run through September 21. We won’t know the exact total until Thursday, but it will be around $25-27 billion. That’s even more cash sloshing around in dealer accounts that will be looking for mischief.

That’s why the market has been so bubbly lately-cash from the Treasury and cash from the Fed.

Well, the gravy train is about to end. The new issuance that’s coming will absorb this extra cash.

Because of the debt ceiling, the Treasury was forced to spend almost all of the $285 billion in cash that it had accumulated since April 15 tax collections. Spending that money helped goose both the US economy and the stock market.

Now it’s all gone.

Not only is all of the cash is gone, but the government also raided internal accounts for additional cash. I don’t know the amount-I’m not sure anybody outside the US government does-but it is probably a lot.

Soon the Treasury will need to come into the market to raise the money to repay those funds and rebuild its cash account to the tune of $500 billion.

As I said, the Treasury always follows the TBAC recommendations, and the miracle is that they publish their estimates a month in advance, enabling us to use them in compiling the LAMPP to figure out what’s probably coming next. That’s a gift, and we’ll gladly receive it for as long as the gift keeps on giving.

The Fed was giving the market a gift over the past eight years by absorbing or financing most new Treasury supply. Even after the Fed stopped outright QE at the end of 2014, it continued to buy $25-45 billion per month in MBS from the dealers. That cashed out the dealers and financed their purchases of the new Treasuries.

By December-if not October-we won’t have that gift. Once the Fed stops buying that paper, the dealers will find themselves with a lot less cash. That means a lot less buying.

Furthermore, the Fed has promised to pull more and more cash out of the system over the year after it begins its “normalization” program, a euphemism for draining liquidity from the markets.

When asked about the Fed, we’ll be able to say, quite literally, “The Fed sucks.”

These flows will show up in both the short- and long-term LAMPP indicators. I expect both to turn red within the next few months.

Stay tuned here for updates.

Meanwhile, continue to use market rallies like this one to sell stock and raise cash to build a significant cushion against losses and to take advantage of future buying opportunities.

Sincerely,


Lee Adler

One Response to “The Real Reason Markets Are Rallying – and Why it Doesn’t Change a Thing”

Leave a Comment

View this page online: http://suremoneyinvestor.com/2017/09/the-real-reason-markets-are-rallying-and-why-it-doesnt-change-a-thing/