T bill issuance continued its upward climb in April despite the Treasury doing a massive mid-month paydown using all that cash it got from mid-April tax receipts.
Dealer takedown of the bills at auction was flat, as the Fed increased its cash withdrawals from the banking system under its bloodletting, aka “normalization” program.
Cash is the dealers’ lifeblood. Sure, they can leverage up, but cash is the basis for that. Under QE, there was always more cash. Under the Fed bloodletting, dealers will have less and less cash to play with.
Meanwhile demand for T-bills from investment funds continued to soar. Since the funds weren’t heavy in cash, this demand must come from them liquidating other investments. Therefore, the declining availability of cash, and the associated rise in interest rates will continue to suck the lifeblood from stocks and bonds as more funds opt to hold T-bills in lieu of bonds and equities.
The Fed has published a schedule of increased draining operations through October of 2018. Then it will maintain a crushing pace of withdrawals until it achieves a “normalized” tight reserve position on its balance sheet. That should take until mid-2020.
Over the next 2 years, dealers will be starved of cash and other buyers won’t be able to pick up the slack because they too will have less cash on balance. Bill rates will continue to rise, as they have been, and stocks should come under increasing pressure. The Fed will be forced to rubber stamp rising money rates by announcing increases in the Fake Funds target rate. That’s a shell game. The real action will be in the secondary market ratees of various maturities of T-bills, where the rise has been relentless, and should continue to be.
Today, I want you to look closely at this chart and notice who isn’t buying!
The declining trend of dealer takedowns began in 2012, mirroring the reduction in Fed QE. As QE ended in 2014, the downtrend in dealer participation accelerated. In October 2017, the Fed began withdrawing a small amount of funds from the system. It increased that to $20 billion per month in January, $30 billion in April, and will increase it to $40 billion in July, and $50 billion in September. This will almost certainly cause dealer participation to fall in the months ahead. In addition, as yields rise, dealers will suffer losses on their purchases if they are not adequately hedged. We have seen clear evidence of that in the weekly dealer data published by the NY Fed. I report that every month in the Wall Street Examiner Pro Trader Treasury Market reports.
In addition to shrinking dealer participation, foreign buyers are also pulling in their horns.
Back in January, I wrote in the Wall Street Examiner Pro Trader, “This [low foreign demand] could be a significant harbinger of more bad things to come. If foreign demand does not pick up as supply increases, this will contribute to the expected rise in rates. The ECB and BoJ are now providing less cash to the system as a result of cuts to their QE programs. That means that the trend of falling foreign demand is likely to continue, especially if the BoJ and ECB continue to cut QE.”
My fears from early in the year are materializing. While T-bill supply has skyrocketed, foreign buying of Treasury bills fell year to year again, falling back to the lowest April level since 2012. Since Trump was elected, Europeans have been fleeing US investments and repatriating the dollars they get by selling them for Euros. Hence the persistent decline in the dollar and rally in the Euro until early this year. Rising rates may have reversed that trend in April, but this chart suggests that the rally is not sustainable.
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As for notes and bonds, the outlook is grim there too. Demand from foreigners declined to a new low in April. The 12 month average of note and bond purchases by foreign accounts is only slightly above the lows set last October. This trend of weak and declining foreign buying is a very bad sign for the Treasury market.
The TBAC has forecast that issuance will rise sharply in the next few years. Both the JCT (Congressional Joint Committee on Taxation) and CBO (Congressional Budget Office) have also forecast big increases in Treasury supply due to the tax cut legislation and the Budget Busting Agreement signed in February. This will be a problem because demand will not be able to keep up. At the same time, the Fed will be draining funds from the banking system, which will hamper Primary Dealer absorption of new Treasury supply. Inflows from FCBs have also slowed, and will probably continue to slow.
Note that the Fed has been picking up an increased share of the debt in the past couple years. The mass quantities of Treasury debt that the Fed had bought under QE began to mature in 2016. The Fed had been rolling all of that over, buying an amount at each auction that was equal to the amount maturing.
That ended last October when the Fed began its bloodletting program of “normalization,” aka tightening or draining. It is no longer buying up all the paper it holds that is maturing. Beginning in October, $50 billion per month will get lopped off the Fed’s balance sheet as Treasury maturities occur and the Fed doesn’t roll over that paper.
To pay off that maturing debt, the Treasury must sell new debt to other buyers. The Fed will simultaneously reduce its purchases of MBS from dealers. The dealers will no longer have as much cash available to buy the increased Treasury debt. It must be absorbed by other buyers in the market. Money is the fuel of demand. With less of it, and more supply to be absorbed, prices will fall and yields will rise.
The rise in competing yields and reduction of available cash should also have a negative impact on stock prices.
The Street and its media handmaidens had pretended to be sanguine about this for virtually all of 2017. But lately there’s been more bearishness. That’s typical of the acceptance, or in the case of a bear market, resignation phase of a major trend change.
As supply increases, the decline in dealer and foreign demand will become a bigger and bigger problem. Falling demand is becoming embedded as the world’s 3 biggest central banks pull in their horns.
Buyers of financial assets, both investors and dealers will find a constant increase in supply and a constant decrease in the fuel for demand until the Fed reverses its tightening policy. With economic data still strong, that’s a long way off. Things won’t change until the markets have a big accident, or as Janet Yellen called it, “a material adverse event. By then it will be too late for you and your portfolio.
Therefore, I continue to recommend getting out of stocks and long term Treasuries. Rallies in stocks are a gift at this point. I’d use them to continue to reduce holdings toward a new goal of 80-100% cash by July, when the next increase in the Fed’s bloodletting schedule is due.