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For now, the long-term LAMPP is still a green light. But the intermediate LAMPP is yellow. Given the Fed's recent statements that it is about to shrink its balance sheet, it won't be long before both LAMPPs turn red.
That means we'll be looking at a number of bearish opportunities soon…
First, let me tell you why we're seeing these green and yellow signals now – where the red is coming from – and then how to profit.
The Fed Is Still Adding Cash to the Bubble – but Not for Long
The Fed holds the settlements of its regular monthly purchases of mortgage-backed securities in the third week of each month. The purpose of those purchases is to replace its holdings of MBSes that were paid down over the past month. That keeps the size of the Fed's balance sheet flat. More importantly, because the Fed purchases the replacement paper from primary dealers, the purchases cash out the dealers. This is still a positive influence on the intermediate and long-term LAMPPs (liquidity and monetary policy profits indicators).
The cash flow from the Fed is essential to the dealers in carrying out their market-making function. Their business consists of accumulating securities inventory for distribution to the public at a profit. That requires cash flow. The Fed necessarily supplies some of that to facilitate the primary dealers in their role of making markets in U.S. Treasury securities.
In July the Fed added $26 billion in cash to primary dealer trading accounts held at there. This is slightly more than the June addition of $24.9 billion. Those settlements took place over the July 13-20 period.
The exact total to be settled in August is not yet known, but it should again be in the $25 billion to $26 billion range. These settlements will occur over the Aug. 14-21 period. The markets frequently get a little boost during settlement week as the cash flows into dealer accounts. But Treasury supply will be heavy this month. That could sop up any excess cash that would otherwise be available to boost stock prices.
The Treasury has scheduled $74.6 billion in new Treasury supply over the period of July 17 to Aug. 10. There could be more supply coming every week until the end of September, when the Treasury has warned it must have a debt ceiling increase.
Treasury issuance is a counterweight to the Fed cash. The Treasury paper must be absorbed by dealers and other institutions. That is a normal feature of the market that would put downward pressure on securities prices in a vacuum where there were no new funds available to absorb the paper.
The current ratio of Fed cash to dealers relative to new Treasury issuance is around .35. That's enough to keep the LAMPP on yellow, but it is on the razor's edge. I expect the ratio to turn red in October, when the Treasury must sharply increase its issuance, assuming that the debt ceiling is lifted.
While the Fed has been much less active in cashing out dealers since the end of 2014, its cohort central banks, the European Central Bank (ECB) and Bank of Japan (BOJ), have taken up the slack. Some of the money that they print for their markets has ended up flowing to the U.S. markets. That has helped to sustain the U.S. market bubbles.
However, the Fed will always be the prime mover of the U.S. market. Foreign central banks are more than bit players, but the Fed is the 700-pound gorilla here. The gorilla has been beating its chest, warning with increasing ferocity that it is about to attack the market. It is no accident that our intermediate-term LAMPP indicator is on a yellow light. We need to be both cautious and ready to slam on the brakes when the Fed turns from chest-beating to outright hostile attack on the markets.
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About the Author
Financial Analyst, 50-year charting expert, finance + real estate pro, and market analyst; published and edited the Wall Street Examiner since 2000.