The Fed has bought mass quantities of Treasuries and MBS over the past dozen years, in what are called Permanent Open Market Operations or POMO. This is just a fancy name for trading with Primary Dealers. We call the Fed’s massive asset purchases Quantitative Easing, or QE. The Fed buys that paper strictly from Primary Dealers with rare exceptions. The dealers then use the cash to buy more paper, whether more Treasuries, MBS, stocks, or other financial instruments.
QE has become the primary source of demand for absorbing the supply of financial assets. The primary source of supply is the US Treasury which has lately been issuing an average of $200 billion per month, or more, of Treasury debt. The market must absorb that. In the absence of QE, prices would be under constant downward pressure. Since stocks and bonds are to some extent interchangeable financial assets, both asset classes would be affected.
The Fed has made sure to print enough money, that is to pump enough cash into the accounts of Primary Dealers, to ensure that prices maintain a steady upward course. The Fed has made sure to engineer QE to all but guarantee bull markets in stocks and bonds.
At some point that could change, and we watch the data carefully in order to estimate when that’s likely to happen.
The QE vs. Supply Equation
QE has thus become the primary fuel that powers demand for financial assets.
The flow of QE cash to the Primary Dealers is almost steady, with a non-material reduction in MBS purchase settlements scheduled for mid month. Meanwhile, Treasury supply, to this point has been steadily enormous, fluctuating within a semi predictable range month to month. Not much has changed since the Fed’s pandemic emergency phase of QE began in March of 2020.
Until now. The big change is that the Federal debt ceiling is now back in force, which means that Treasury issuance will first slow, and possibly stop, until Congress raises the debt limit. This will reduce new Treasury issuance. Supply will be constricted. The reduction in supply could give the bond market rally a second wind, or it could accrue to stocks, or both.
So it will be bullish for awhile. Then it will stop. Then we’ll have a Wile E. Coyote moment. And then it will end. Badly. Here’s the how, why, and the timing.
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