The FRNY has already de facto replaced the risk-assumption function hedge funds provided until last year.  Now the Treasury wants in on the action.  From the Treasury’s morning release of the TBAC Minutes:

 The presenting member then discussed interest-rate volatility. Both realized and implied volatility remained at elevated levels relative to historical norms, with long-term rate volatility significantly higher than front-end rate volatility. The negative convexity profile of the mortgage market has increased with the QE purchases but it is difficult to hedge the convexity in the current market. This is because there are no natural sellers of volatility left in the market, following the collapse of hedge-fund capital, despite overwhelming demand for volatility from mortgage servicers and originators; this has created a chronic structural net short position in the market place. The presenting member suggested that Treasury, if it wanted to be opportunistic, could potentially benefit from this demand for volatility by offering putable issues.

So the Treasury would issue a security that it would agree to buy back at a fixed discount to par, thereby establishing a ceiling on its yield and a floor on price.  Sign us up.  Why would we ever buy regular Treasuries again?

Some thoughts on the TIPS (inflation linked securities) statements in the Minutes are below. 

The Committee then moved on to the second item in the charge concerning Treasury inflation-indexed securities. Specifically, Treasury asked the Committee if there were any changes to the TIPS program that Treasury should consider in order to improve TIPS market liquidity and maximize the diversification benefits of inflation-linked debt issuance.

The presenting member began the presentation by noting the original reasons given for issuing TIPS. Considering lowest cost over time, the presenting member noted that much of the criticism of TIPS has been based on ex-post cost measures which have shown a high cost. The presenting member also conceded that TIPS had not diversified the investor base to the point expected, but noted that some new investors to the asset class had recently been observed.

The presenting member remarked that lowest cost over time and the diversification of the investor base were not the only goals of the TIPS program. According to the member, the original individuals who introduced the program were keenly interested in TIPS as a real-time market estimate of inflation as well as being a way of having the government to monitor its fiscal balances.

Many are talking about China or whoever pressuring the Treasury to up the TIPS issues.  China knows it’s getting zero cents on the dollar in 30 years with anything currently issued by the Treasury–TIPS or no TIPS.  This is really about managing public perceptions about inflation and Uncle Sam’s fiscal responsibility.  We still have an inflationary long term view of the US economy, despite our current short term deflationary view, because eventually, the parabolic monetary base will become parabolic M2.  Inflation is the tipoff, and masking it buys prescious time.  So, with expansion of the TIPS issues, (1) there is the PR benefit that people may believe the government has an interest in keeping inflation low (and monitoring its fiscal balances), (2) it reduces the illiquidity premium that comes from a thin issue base, which will make inflation look lower (to those that are unaware of the illiquidity premium), and (3) having the CPI embedded in a liquid Treasury product gives the understated CPI more authority.  As CPI (both headline and core) is gamed, the Treasury needn’t worry too much about payout–even on the 5′s. 

The member then moved on to the next set of slides which discussed the changing investor base. Using internal estimates derived from experience with the asset class, the member estimated that 60% of the TIPS investor base is dedicated to the asset class while the remainder use TIPS for tactical trading purposes. Of those 60%, a large portion – far greater than nominal Treasury securities – are retail investors. The rest were mainly pension funds, endowments, central banks, and sovereign wealth funds. The member noted that these foreign flows were concentrated in short maturities (5 years and under) to avoid duration risk.

One member noted that pension funds were the source of large outflows from TIPS due to disbursement needs and the illiquidity of the alternative assets in their portfolios. This flow may re-emerge in the future.

The presenting member then turned to the recommended actions. The member stressed more frequent but smaller auctions and a commitment to 5 year issuance as being the most important to supporting the market. In addition, the presenting member suggested replacing 20-year TIPS with 30-year TIPS and increasing TIPS as a percentage of the portfolio. The Committee then discussed the presentation as well as the recommendations.

Why replace the 20 with the 30?  Besides postponing the inevitable payout, there is no 20 year regular Treasury.  However, a 30 Year TIPS can be directly matched with a 30 Year bond to precisely guage inflation expectations, which furthers the inflation perception management hypothesis.

Members remained cautious about the product, citing past discussion of program’s cost, but, given the government financing needs, did not recommend a reduction in issuance. Members did stress that TIPS remain more expensive on a LIBOR basis than the most expensive nominal security.

Another member countered that if the US experienced a period similar to that experienced in Japan in the late 1990′s, TIPS could well prove to be cheap financing for Treasury.

Just like TARP will make the taxpayer a nice return!

One member thought that if central banks were increasing their involvement in TIPS they would be an important future player in the TIPS market.

Regarding changes to how TIPS are auctioned, members voiced no objections to smaller, more frequent auctions if Treasury could overlap them with short nominal coupons. One member suggested Treasury issue shorter duration TIPS. Another member suggested Treasury consider subscription issuance or reverse inquiry as a way of targeting the buy and hold investors which represent a diversification of the investor base.

Several members were concerned that after twelve year of TIPS issuance a liquid inflation swaps market had not developed and no other issuers had emerged. One member remarked that the issue was related to the choice of indexing to headline CPI rather than core CPI. The member said headline CPI was too volatile, too much of a play on commodities for the typical fixed-income investor and left the government effectively playing the commodity market rather than supporting long-term inflation hedging needs.

This will be the eventual excuse when the government says it will retractively fit TIPS to [lower] core CPI as opposed to headline.  Because long term inflation hedging needs are best served by erosion of principal.

The Committee then turned to the recommendation of replacing 20-year TIPS with 30-year TIPS. Several members noted that the 20-year TIPS point was an anachronism of the auction calendar, noting that the 20-year TIPS introduction was at a time when there was no issuance of 30-year bonds. Other members underscored that such a movement would increase the amount of duration for market participants to absorb at auctions and potentially create a security which traded cheaper to the curve. On balance, it was suggested that moving 20-year TIPS to 30-year TIPS seemed like a reasonable course of action.

Additionally, several members found the behavior of TIPS in the second half of 2008 to be disconcerting. Members said TIPS illiquidity left investors with less than the safe government bond they thought they were buying. Another said that perversely investors ran from TIPS during a flight to quality. Another said flights to quality are really flights to liquidity, which TIPS lack. Members agreed that TIPS do not have the liquidity that typically characterizes government bonds.

And they will solve this by upping the issuance.

DAS Rutherford asked the Committee what actions Treasury could take to show its commitment to the program. Several members stated that increased TIPS issuance could be considered, but for financing reasons and not for cost reasons.

The Committee agreed that given debt issuance needs, this was not the time to “cut” issuance, and to remain committed to the program, Treasury could once again publically affirm its commitment as well as move to 30-year TIPS security. It was noted that given the large financing needs which Treasury faced in the coming years, issuing additional TIPS to address those needs in addition to nominal issuance should be considered.

Suggested reading by economist Bob Murphy is here.

The Bureau of Economic Analysis (BEA) released its monthly Personal Income & Outlays report today for June 09, having retroactively revised their methodology for all previous data to 1929, with most of the material revisions only affecting the last ten years.  Many have looked to this over the past few months and pointed to the increase since last fall in personal savings, which is defined by the BEA as Disposable Personal Income minus Personal Outlays (expenditures).  Though we quarrel with this definition of savings, that’s a subject for another post.  We think it’s ridiculous to assert that people are saving more by any definition because incomes are being reduced and are causing the debt servicing burden to be higher, not lower.

Last month, we compared the May 09 period to October 08 in the BEA’s spreadsheet to find out from where this apparent savings increase was coming.  The reason we chose those two months was simply because Oct 08 was the oldest data available in that particular spreadsheet (and May the latest).  Today, for a quick exercise, we took the June 09 report (download here to follow along), inserted the May 09 to Oct 08 comparison column from last month’s spreadsheet (calculated under the old methodology) into column M, created a new column N that shows compares May 09 to Oct 08 under the new methodology, and inserted another column P comparing the latest data (Jun 09) to what is now the oldest data in the spreadsheet (Sep 08). 

What we found is quite shocking–not only the deterioration in personal income since last Sep/Oct, but the deterioration as a result of the revised methodology.  Last month’s (May) report showed a $98.1 B increase in Personal Income from Oct to May, but now shows a net decrease of $173.5 B.  From Sep to Jun (the period used from here forward), it is much worse at -$371.7, most of which is from private compensation, which fell off a cliff (though gov’t compensation increased).  The blow to Personal Income was softened by an increase in government social benefits of $212.6 B (despite the fact that the amount paid in decreased by $54.8 B–is this sustainable?).  Personal taxes paid are down $410.4 B (nearly 33%), so record deficit spending is here to stay.

On the Personal Outlays side, all that has been increasing are payments to the government (only by a small amount), and for services in the amount of $38.1 B.  We wonder why the huge uptick in services?  Are people getting more massages, or might these be debt consolidation, mortgage refinancing, and loan modification services?

Also, we note a glaring fault in the Personal Outlays methodology (at least based on the presentation in the spreadsheet–if someone knows otherwise, please tell us).  Apparently, only interest payments are counted as expenses, and not the principle.  So, if you finance a car or a buy a new tv (or tv dinner) with your credit card, the entire amount is counted for that month by the BEA as an expense.  The principle that you pay each month for the next x years is not counted as an expense in the future months (though the interest is).  So, people are buying fewer Hummers now, but still making payments on their old one, with the principle not being counted as an expense.  We understand why the BEA might do this for durable goods–because they retain value; however, we don’t even see a depreciation deflator and certainly cannot justify this for non-durables.  We pose the following questions to readers:

Do you count your car payment as an expense, or do you consider yourself to be saving the principle?  

When you pay principle on your credit card accounts (assuming you carry a balance), do you consider yourself to be saving the unpaid amount of the dinner you charged last month?  It looks like the BEA does.

In conclusion, it’s not difficult to imagine that the savings rate has been negative and getting worse.  And, the increased largess of Uncle Sam has only distorted these figures all the more as it’s difficult to imagine that payments made to the unemployed and those on social security are being saved. (Again, not by our definition of savings–the BEA’s).

With M2 money supply decreasing and consumer spending 70% of GDP, we don’t see true recovery soon.

The Precise Take – 7 Year Auction buys time for bonds as equities finish record strong month

We were at a crossroads this week contemplating that our primary theory of the markets, the dominant theme of which is the interplay between US Treasuries and equities, was no longer or was never correct.  After yesterday’s 7 Year auction, we are more convinced than ever that this is the case, and that the markets are caught in a tug of war between Bernanke’s Federal Reserve (FR) in Washington attempting to keep down long term interest rates and Dudley’s FR Bank in New York (FRNY) trying to keep equities on a tear for the large member banks.  The administration prefers both as they help keep public opinion from swelling to be too negative and hurting the chances of pursuing its agenda (which is already in danger). 

The entire week’s price action in the ES with all its zigs and zags could have been forecast in two scenarios as early as last Friday, with the correct scenario being known Tuesday afternoon.  It involves the varying dynamics of (1) the paint-the-tape closes induced by permanent open market operations (POMO) by the FRNY, (2) the Treasury-supportive signals broadcast early in the week in the EuroYen forex cross as well as the gold and Treasury futures markets (to this we note that the FRNY contains massive gold holdings as well as foreign currency reserves in exactly two currencies—the Euro and the Yen), (3) declining M2 non-seasonally adjusted which has a strong historical tendency to increase volatility, (4) the record Treasury auctions that needed to show enough demand to prevent a dangerous rise in yields, and (5) the need for equities to close the month on a high note.  It was as to 4 and 5 where we went slightly askew because 5, above, was the priority (equities needed to post as much gain as possible end of month) and, as to 4, we had hypothesized that Treasuries needed to rally at the expense of equities whereas they actually only needed to tread water until the eventual equities takes place. 

As an aside, M2 NSA as reported yesterday continues to shrink, thus increasing the likelihood of continued or increasing volatility.  A reader correctly commented yesterday that the FRNY’s POMO forays are money printing.  However, this increase in the monetary base is not working its way into M2 for whatever reason, and it is M2 that has the most effect on the economy and not M1 or M0 (the monetary base).  Historically, the Fed has had little control over M2, but we suspect that, with its increased powers, the Fed has more control than previously and may be intentionally counteracting the money printing of the NYFR.

To further support the priority of a strong equities close, the FRNY announced yesterday it would conduct POMO for Agency securities (Fannie/Freddie) today, and we commented pre-auction yesterday:

After $3 B yesterday and $6.5 B today, another (probable) $1.5 – $3 B tomorrow [Friday] in Fed funny money sent to banks that can be leveraged 100x or more should give the bears pause, especially into month end (tomorrow).  Our question is, what is the NYFR so worried about?  The contrarian in us would believe it’s to overcome a weak GDP report tomorrow and/or a very strong 7 year auction today.

That the 2 and 5 year auctions did not send the 10 and 30 Year futures down by 3 or 4 big points into Wednesday afternoon was evidence enough that demand was being saved for the 7 Year.  As we updated yesterday post-auction, “Bernanke has probably bought himself two weeks of long term yield control until the August 12 10 year auction is conducted.”  We will by tying all this together in a more comprehensive report over the weekend that includes possible scenarios for the next couple of weeks.  Register free here to receive this and other updates.

The time profile for the day after a POMO day (as was yesterday) that is also a POMO (A) (n=5 since May 09) shows a strong tendency for the ES to head down and bottom in the first hour, with no clear further bias until the close, which shows a strongly bullish bias.

As we write, GDP has clearly disappointed as expected; however, equities are ensured a good close as we find a close below 973 unlikely.  In light of the new comprehensive analysis above, we are removing our 1008 target and suspect…

Continue reading here.

11:27 am EDT:  The ES has not looked back as it has headed all the way past day-session-only R3 and weekly R1.  Globex daily R3 at 995.75 is all that remains until confluence of weekly R2 and the old Nov 5 08 high at 1008.50 to 1008.75.  Again, we’re not fading short at these levels, but would wait for a pullback to 988 for new longs as we’re unlikely to post meaningful gains for a while.  We only get intraday bearish below 982 now.   

Today’s POMO auction, for what it’s worth (though we stipulated by itself it would not give a bullish edge) was for $6.5 B, larger than yesterday’s $3 B.  Assuming equities can hold on to their gains through the 7 Year auction at 1:00 pm, we should get additional gains into the close because of momentum alone.

Longer term:  Below is a gold chart that shows the consolidating wedge developing off 61.8% retracements (marked 1, 2, 3 and 4?).  The last would see a rise to about 947 should it occur, then reversal down again.  In this highly technical and standout pattern, a breakout will be watched closely as a signal to the direction of the markets and economy.  To the upside (bullish for equities), gold has the potential to finally move beyond the 1,000 level.  To the downside (bearish for equities), we see 800 as a target.

Thanks for all the responses to Sunday’s post on M2 Volatility and the potential consequences to the markets over the next three years.  A few follow up points based on reader questions:

Q.  Are you advocating shorts instead of longs now? 

A.  No, we are not advocating any positions based on this phenomenon.  #1, Heightened M2 Volatility is not a precise timing signal, only an indication of a probable eventual decline and probable increased volatility in the next three months.  #2, We monitor the markets on a daily basis and will alert if and when we see a top forming.  If equities posted their top yesterday, one day after our report, that would simply be a coincidence.

Q.  Then why issue such a dire warning?

A.  We feel the greatest damage will be done to inexperienced traders and passive investors who only exit the market after experiencing significant losses.  This, in turn, can damage market functionality as money heads elsewhere for a protracted period of time. 

Q.  What is your advice to experienced traders?

A.  We simply recommend giving more weight to distribution days.  Tighter stops may not be feasible because of expected greater-than-normal volatility.  So, selection criteria (for stock pickers) is critical.  For day traders, don’t get caught on the wrong side of the market because we expect ranges to widen.

Q.  Do you see any similarities to the 2001-2002 bear market?

A.  Yes, and unfortunately, it looks much worse now.  The July 20 01 low in M2 Volatility (yellow in the chart below) was a higher low than the previous year, and the higher high in M2 Volatility in the week ending September 21 01 (which coincided with the spike low in the S&P 500) was the end of the broadening wedge in M2 Volatility that began in 1995.  The next year, the three month period following the July 19 02 low in M2 Volatility (which still had a high 12 month range), coincided with the low of the bear market in the week of October 11 02, and M2 Volatility from then on contracted into until about mid-2006.  By mid-2007, it was apparent that M2 Volatility was again increasing, and we had the high in the three month period following July 20 07 (after a steep drop into mid-August 07).   Presently, M2 Volatility is still broadening, making new record highs and new lows.  Though the study by itself did not imply causation, if you believe (as we do) that M2 Volatility causes crashes and is not merely correlated with them, the effect of record M2 Volatility on markets should be greater this year than in any other going back to inception of weekly M2 data in 1981.

In response to our previous post and chart on this topic, several people asked for a statistical analysis to accompany the graph.  Hopefully we’ve enhanced the explanation and can issue a proper warning, which, after thorough historical analysis, seems all the more warranted.  We will be developing and expanding on this post in the weeks to come, but submit the following background and preliminary findings:

Background and Summary Findings:

• M2 is the broadest form of money supply currently reported by the Federal Reserve and we have found that large changes in it (what we call M2 Volatility) coincide with stock market volatility and significant price corrections in a critical part of the year–the third week of July to the third week of October.
• M0, the monetary base, though more commonly touted by economists, does not appear to be a good predictor of stock market volatility or of potential stock market corrections (data to be presented in the future).
• Specifically, we use M2 non-seasonally adjusted (NSA) because we have found that the very seasonality (volatility) that the Federal Reserve attempts to remove from the data is what is most correlative with stock market volatility and corrections.*  The Fed publishes M2 NSA along side M2 SA for all to see, so there is no conspiracy–they are simply a bit short-sighted in stressing M2 SA.
• As M0 and seasonally adjusted data are the norm, we believe this analysis is important because it addresses a potential hazard to stock market prices heretofore not widely addressed*.
• Based on an analysis of M2 Volatility in the three month period commencing the end of the third (approximate) week of July and into the third week of October for the past 28 years, we believe that this year, 2009, (1) there is a significant chance of a large (average ~17%) eventual correction as measured from the close of July 17 09, (2) there is a significant chance of increased volatility as measured in percent price range over the period (average ~20%), and (3) that, based on M2 Volatility, equities are in a more precarious position than last year at this time, which experienced a 33.38% loss in the corresponding three month period.

Explanation of graph:

• At the top of the above graph, in the first subgraph is the S&P 500 cash index going back to late 1981 with M2 plotted in cyan, with its 13 week (one calendar quarter) moving average. Weekly data for M2 goes back to January 1981, though monthly data (not usable for our purposes because of low resolution) goes back to 1959.
• The yellow indicator in the second subgraph (M2 Volatility) is the percent change of M2 from its value 13 weeks prior.  The yellow trendlines were hand drawn and show secular trends in the broadening and  contracting of M2 Volatility. Note the percent change is not annualized.
• In the third subgraph are the 12 month (bright red) and 6 month (dark red) ranges of basis point (bp) swings (divided by 100 for presentation purposes) in 13 Week % Change M2.  Basically, they represent the 6 and 12 month range of M2 Volatility.
• In the bottom subgraph is the 10 year US T-Note yield minus the 13 week US T-Bill yield (the 10 Yr – 13 Wk spread), which is one of the simplest representations of bank lending profitability.  The greater the spread, the more profitable it is for banks to borrow on the short cheap end and lend at the more expensive long end.

A closeup of the above graph of the last five years only is here:

Preliminary observations:

• It is immediately apparent that M2 13 Week % Change (M2 Volatility) has been broadening since mid-2006 with higher highs and lower lows.
• As of last week’s M2 figure (reported July 23 09 at 4:30 pm), the 12 month spread (bright red / third down) reached its highest level (674 bp / 6.74 percentage points) going back to 1981.
• There is an approximately quarterly periodicity to extremes in M2 Volatility (yellow).  This lends credence to the theory that money supply tends to exert its influence in three month increments.

Looking further at the quarterly periodicity of M2 Volatility (yellow), most years tend to display the same temporal pattern of peaks and troughs as the previous years.  Eventually, however, the pattern breaks, the relative importance of which will be researched in the future.  In general, the spikes tend to occur in the last week of December/first week of January, the third week of April and the third week of July, with April usually up and July usually down.  There is a notable absence of any regular high or low in M2 Volatility in October, as might be expected at this quarterly mark.

The periodic spike up in the third week of April appears to be particularly important because if M2 contracts too much over the summer into the third week of July, there is a tendency to have a correction in the S&P 500 going into the third week of October. Because we are now closing the third week of July and because most major market corrections are underway into the third week of October**, we will be looking at this three month period exclusively in this report.

Data:  The above graph is 1981 to present, as before, but marked with vertical lines to show the third week of July spike low (red) and the third week of October (gray).  Data from the graph was exported to a spreadsheet for further analysis and to identify key thresholds.   

Analysis:  In the 28 year sample, at the beginning of the three month period commencing at the end of the (usually) third week of July, a (1) 13 Week % Change in M2 (M2 Volatility) (4th column) less than 0.2% along with (2) a 12 month M2 Volatility basis point (bp) spread (6th column) of 320 or more , has coincided nine times with declines of 9% or more measured from the close of the weekly bar at the beginning of the period to the low set in the following 13 weeks, with the average decline being -16.69% [stdev 10.39%, n=10] versus an average decline for other years of -4.12% [stdev 3.79%, n=18].

Two failures were 1) a false positive when the three month period in 2006 met these parameters but had no low that was lower than the close of the beginning week, and 2) a false negative when for the -15.72% decline in 1981, which had a beginning 13 week M2 Volatility of 1.08% (materially greater than 0.2%), but did fit the second criterion, having a max 12 month bp spread of 358.

For the three month periods that did not fit the two criteria, there were average gains of 7.07% [stdev 6.61%, n=18] versus average gains of 4.76% [stdev 4.79%, n=10] for those that did.

The 12 month bp spread of M2 Volatility set for the week ending July 17 09 is an all time high and the beginning M2 Volatility was -1.04%, the second lowest after the July 21 2000 -1.44% reading.  The one saving grace of this period is perhaps the 10 year-13 week Treasury spread of 3.49%.  The largest loss during the three month period with a Treasury spread greater than 3.00% was -8.74% in 1982 (which also had a 24.89% gain), with an average loss of -4.69% [stdev 3.08%, n=6] and average gain of 9.48% [stdev 10.98%, n=6].

When the beginning 12 month bp spread in M2 Volatility was greater than or equal to 320, the average percent range of the S&P 500, or what could be characterized as price volatility, from high to low in the three month period (range / price at beginning of period) was 19.25% [stdev 10.05%, n=13] as opposed to 11.05% [8.13%, n=15] for other years.

Conclusions: Two caveats with respect to the data are: (1) the sample size is small and the average gains/losses are often with the standard deviations, and (2) the boundaries chosen in the two parameters to coincide with 9 of the worst declines are a bit arbitrary, so measurements at about the boundary areas could probably go either way.  What is clear is that we are in no way close to the boundaries for the current three month period in 2009.  And, while the data presented here do not imply causation by themselves, they do confirm correlation of M2 Volatility with stock market prices. 

What we might expect is not only a large eventual correction (ranging in the 9.33% to 33.38% [avg:  16.69%] experienced in previous years), but also a wide price range over the next three months into the third week of October (avg: 19.25%) .  So, while prices can certainly climb higher, there is great danger that all but the most nimble traders or long term investors (with no stops) can be eventually shaken out.  Much of the retail money that left the equities markets last year was permanent, and a second year of thrashing poses an even greater threat to the long term health of the markets.

Further, we noted the possible saving grace that Treasury spreads are high now, which can induce banks to lend and support equity prices.  However, the Fed’s new ability granted by Congress to pay interest on excess reserves held by banks at the Fed can easily erase this potential benefit, and further studies on actual lending activity are warranted.

______________________________________________________

* Thanks to Robert Wenzel, editor of EconomicPolicyJournal for suggesting the use of M2 non-seasonally adjusted as opposed to seasonally adjusted, and for noting the similarity of contracting money supply in 2009 versus 2008, which was the impetus for this study.

** Robert Wenzel points out this is because, “it is the period of great consumer intensity away from savings and toward consumption. New school clothes, winter clothes and preparation for Thanksgiving and Christmas. From mid-August to December, October is at the vortex of a shift toward consumer buying, away from savings–which includes stock liquidation.”

First, a caveat that this data is over two months old and as of May 9, 2009.  Foreign purchases of long term US Treasuries went from $17.1 B in April to -$21.8 in May–absolutely abysmal.  What appears to be weighing on long term yields (which should have shot up immediately on this data point alone) is the huge increase in China’s holdings of US Treasuries (short and long term), going from 763.5 in April to 801.5 in May (+$38.0 B).  How is this possible if they were only net buyers of $4.0 B in long term Treasuries during the month?  One, they could have stepped up purchases of short term Treasuries, which in the long term is meaningless as to their confidence in the US Dollar.  Two (more likely), the massive net purchases by the UK of long term Treasuries in April of $16.4 B could have been conducted by China using UK domiciled vehicles, as China has done at times in the past. Notably, purchases of long term Treasuries by the UK were again very high for May at $14.2 B. Combined with the record support for the recent Treasury Auctions, this is bullish for long bonds and 10 year notes and bearish for equities over the coming months.

In line with what we wrote in this morning’s report, if long term Treasuries were to make new lows (and yields new highs), the US greatly jeopardizes its ability to finance its upcoming debt needs and the risk of inflation actually increases again as a halt in appetite for and mass repatriation of US debt would require the Fed to buy everything in sight, financed only by the printing of money.  Again, this scenario is too risky to chance, but anything more than a nominal new high in the S&P will indicate this nightmare scenario could occur and the Fed must be aware of the possibility.

Ideally for the Fed, equities and Treasury yields go sideways until we complete the refinancings, defaults and deleveraging that are necessary before the actual recovery can take place.  Clearly, though, the S&P 500 cannot stay in a 100 point range for the next year, so something will give.  Given the mid-term election cycle that will begin next spring in the US, another leg down in the stock market (even a new low) does not truly hurt the current administration if recovery appears to be underway next spring, which would mean a rally off current or new lows has been in place for a few months.

Another scenario (less likely) that we must consider is that the S&P breaks 1,000 and yields make new highs, but does not become unmanageable.  The stock market then begins a very choppy ascent, making only marginal new gains with frequent corrections.  This is ultimately inflationary too (with more risk to the Fed), but could be more palatable to the administration as it will find more public support for its agenda

Tomorrow, we’ll look at today’s 4:30 pm M2 report for additional long term market directional clues.

Click for giant chart.

Our long term bullishness on equities is predicated on increasing money supply and relatively low borrowing costs.  As of yesterday’s report by the Federal Reserve, M2 contracted materially on a non-seasonally adjusted basis for the month of May.  This could be a repeat of Summer 2008 with a major interim top in equities if M2 continues to shrink or even stays flat.  Accordingly, we are adjusting our long term forecast from bullish to neutral, awaiting more data over the next month.  A key difference between this summer and the previous is the substantial increase in the supply of Treasuries and funding needs of the US government.  Without the Fed printing money to purchase Treasuries, supply will force Treasuries lower and yields higher, as oversold as they may already be.   Shrinking M2 has a double whammy effect on stocks because the amount of money available for borrowing falls and interest rates rise.  This rally was kicked off with a precipitous rise in money available for borrowing over several months as well as low interest rates/borrowing costs.  With less money available for borrowing and now higher interest rates, we expect this to weigh heavily on equities.  This is not a short term signal, but one that will play out over the next month or two.  Accordingly, we can still see a short covering bounce in Treasuries and new equities highs, though we believe they will be reversed dramatically, unless there is a material increase in M2 or lowering of interest rates.

Click for larger image.