I thought I would start reviewing the events on Friday. But description without analysis is sterile. It leads nowhere, and we want to get somewhere with all this much writing.
What sort of analysis am I referring to? Lately, almost every piece of research on the state of the markets points at the enormous slack building up in the global economy. Capacity is not fully used, labour is not fully employed. This situation is evidently deflationary. Market analysts, who spend impressive amounts of intellectual capital deciphering loads of statistics, write with a tone of frustration, that they find ironic to see stock and commodity prices increasing. This so called bear market rally, in their opinion, is bound to finish in tears.
I must say it is easy to agree with this analysis. However, there seems to be a critical contradiction. When the markets were plunging in 2007-08, these analysts were quick to point out that the phenomenon was due to deleveraging. And they were right! There was no use in focusing on fundamentals. It did not matter whether a company had a quasi-monopoly, or a healthy balance sheet, or good management. The relevant factor was that investors were running for cover and liquidity was the key to survival. If it is illicit to regard fundamentals in times of deleveraging, why is it allowed to consider them, in times of leveraging?
Ah, but who is leveraging? Yes, it is hard to think along this line, but if the Fed is “creating” billions every week to outright purchase debt from the U.S. government, then someone is leveraging its investments. That someone is the U.S. government. The U.S. government (the Treasury and the Fed) is buying the distressed assets from the U.S. private sector, with leverage. That leverage is the amount of resources the government does not currently have (i.e. has not taxed yet…).

If this “axiom” sounds reasonable to you, let’s now face the next question: Why would stocks and commodity prices rise?
In short, stocks and commodity prices may rise because the existing holders of government debt and distressed assets bought by the U.S. government take advantage of the bid by the Fed, which is a unique window of opportunity, to unload their holdings and FLEE to safer assets. I may be wrong, but I think I saw a bit of this happening last Friday (April 17th)…
On Friday, the market was expecting the Fed to purchase GSE (Government sponsored enterprises: Fannie Mae, Freddie Mac and the 12 Federal Home Loan Banks) debt, between 10:30 and 11:00 am (This schedule is known by market participants in advance). The expectation was that the Fed would target the Oct/15 and Jul/32 issues. Buyers of these issuances usually want to keep only what is called the credit spread, or the spread net of inflation. How do you do this? You buy the GSE issue and sell the Treasury issue that matches the term. For instance, in the case of a 30-year GSE bond, you would sell the 30-year Treasury. At about 9:30am on Friday, it was interesting to see how both the 10-year and 30-year Treasuries were being sold by speculators, driven by what I thought was the expectation that after conclusion of the sale of GSE debt, GSE investors were going to hedge their purchases (i.e. sell Treasuries). This made sense to me. Why would you want to keep Treasuries that you know have an inflated price (sustained by the Fed purchases) into the weekend, when you know that by mid-morning, more sellers will show up?
This is what you could see on Bloomberg by 10:30 am on Friday (Feb/19 Treasury on the right, Feb/39 Treasury on the left)

If my theory was correct, after the sale of GSE debt, when buyers sell Treasuries to hedge their spreads, we should see another sell-off in Treasuries. The Fed bought $3.07BN out of a $5.66BN submitted (par amounts, mostly in the 7+ years)
We could see this on Bloomberg by 12pm on Friday (Feb/19 Treasury on the right, Feb/39 Treasury on the left):

What would sellers of Treasuries now do? Flee to “safer” assets? Commodities? Stocks? Other currencies?
We could see this by 12pm on Friday (From left to right: Crude Oil, May 09 contract; S&P500; Canadian dollar):

The S&P500 finished the session up 0.5%, at 869.60 points. Is it possible to see a weaker USD (in terms of Canadian dollars) and stronger S&P500? Yes, if the asset allocation from Treasuries to stocks is not interpreted as a vote of confidence on the U.S. economy. In summary, it seems to me perfectly possible (and consistent) to see commodities and stocks “rally” while the macroeconomic picture is deflationary. This is what Gottfried Haberler referred to as “relative inflation” (see letter of April 14th). In fact, the opposite (i.e. Fed injecting liquidity while stock prices do NOT increase) would seem to me an oddity, because it would mean that inflation brings full employment and economic growth. Readers’ feedback is welcome.
Lastly, the graph below shows how the market had behaved by the end of the session on Friday: