I have been telling you since last September about the Fed pulling money out of the market, and how that causes a problem on the demand side of the investment markets’ equation.
This year I have been telling you also about the problem on the supply side of that equation. The US Treasury has gone from hitting the market with an average of about $50 billion per month in new supply of Treasury notes, bonds and bills, to an average of $100 billion per month now and as far as the eye can see into the future. There’s nothing on the horizon from a policy or economic perspective that will reduce these deficits.
Those massive deficits created by the tax cut and the Congressional Budget Busting Agreement (BBA) signed by Trump, will endlessly stimulate the topline US economic data to rise at warp speed while middle class manual labor jobs will continue to disappear, hollowing out the economy.
That’s a long term problem. In the short run, the problem for the stock and bond markets is the supply demand equation. It is getting worse as the Fed pulls more and more money out of the system, hurting demand, and the Treasury pounds the market month after month with massive amounts of new issuance. Somebody must absorb all that supply, and increasingly, there are fewer classes of buyers who are able and willing to do so.
Let’s peel the onion a bit to see one layer of what I’m talking about. Make no mistake, this is already affecting your portfolio if you own bonds, and it’s about to affect your portfolio if you own stocks. Stocks and bonds are merely different classes of the same thing-investment paper. Money moves freely from class to class.
And with less and less money around to absorb the constant stream of new supply, that’s a problem that won’t go away. Not only that, it will get worse.
More Paper, Fewer Buyers – And A Death Spiral for Your Money
The US Government has been borrowing insane amounts of short term money. That short term borrowing comes to the market in the form of weekly auctions of Treasury bills. T-bill issuance continued its upward climb in May as the government needed to borrow more and more money to cover the massive, growing budget deficit. This chart shows that, and it shows who is buying all that paper. The trends are telling.
The biggest buyers are still the Primary Dealers, those investment banks appointed by the Fed to be first in line to purchase US Treasury debt, and to get to deal exclusively with the Fed as a counterparty. That was great for them when the Fed was cashing them out with QE, week in and week out.
Not so much.
Dealer buying of T-bill issuance rose in May, but at a slower rate than total issuance. This is the second year of that divergence. Dealer liquidity is tightening as the Fed increases its cash withdrawals from the banking system under its balance sheet bloodletting, aka “normalization” program. The problem will worsen in July when the Fed increases its bloodletting rate from $30 billion per month, to $40 billion, and again in October when it goes to $50 billion per month.
It will also get worse in September when the ECB cuts its QE from €30 billion to 15 billion. Remember! 15 of the 23 US Primary Dealers are subsidiaries of foreign banks. 8 of them are European with a direct conduit to the ECB. And most of the 8 US based dealers also have a direct line to the ECB. As the Fed drains and ECB cuts back on QE, the dealers will have less and less cash to play with.
In a real world case of dumb and dumber, demand from investment funds continued to soar in May. We know from seeing how badly dealers have been mispositioned at major turning points that dealers aren’t exactly smart money. Let’s face it. They’re so smart, they practically destroyed the entire world financial system in 2008.
But investment funds are even dumber. Since the funds have not been heavy in cash, their heavy buying of Treasuries must come from liquidation of other investments.
Constant massive funding demand from the Federal Government, and the declining availability of cash will continue to suck the lifeblood from the money markets, sending short term rates and bond yields soaring. We should have no doubt that stocks will get their turn in the barrel. For now, liquidation of stocks and bonds has come in rotating waves. Within the next few months I expect the waves of selling to be concurrent.
With the Fed increasing its draining operations through October, the dealers will get less and less cash from the Fed. If other buyers don’t pick up the slack, bill rates should continue to rise, as they have been, and stocks should come under pressure. The Fed will be forced to rubber stamp rising money rates by announcing increases in the Fake Funds target rate.
Notice who isn’t buying! While T-bill supply has skyrocketed, foreign buying of Treasury bills plunged year to year to an all time record low for the month of May. Foreign buying of T-bills has dropped from around $19 billion per month in May of 2015 to around $7 billion now.
Since Trump was elected, foreign investors and institutions, particularly Europeans, have been fleeing US investments and repatriating the dollars they get by selling them for their local currencies. Hence last year’s persistent decline in the dollar and rally in the Euro. That only reversed this year as US money rates rose, attracting some dollar buying, and also because American companies brought cash back to the US due to the corporate tax amnesty. But that was mostly a one shot deal. This chart suggests that the dollar rally is not sustainable.
|From the Wall Street Examiner Pro Trader: 1/23/18: This 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.
Now let’s look at the issuance of Treasury notes and bonds (coupons). Year to year gross Treasury coupon issuance surged in May. The uptrend in supply has now persisted for 3 years. Supply increases are now accelerating thanks to the tax cut and Congressional/White House BBA.
Here again, while supply is at a new all time high for the month of May, dealer buying has not kept pace.
That’s right-all time- supply is higher than during the TARP, the US Treasury’s financial bailout program in response to the 2008 financial crisis. This is ongoing evidence that dealers no longer have the cash to buy as much of the Treasury issuance as they did in the past, when the Fed was cashing them out with QE every week.
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 probably cause dealer participation to fall even more in the months ahead. In addition, as yields rise, dealers will suffer losses on their purchases if they are not adequately hedged. We’ll look at that in a subsequent section, but it’s no accident that the price of Goldman Sachs (GS) stock has been getting pummeled for months.
Somebody must pick up the slack for bond prices and yields to remain stable. But not enough classes of buyers are stepping up. The result is what you see on this chart.
There’s a lot more instability and volatility in the bond market, thanks to the use of leverage, but there’s no mistaking the trend.
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, the Fed, ECB, and BoJ, pull in their horns.
What to Do with Your Stocks And Bonds – And When
Foreign buyer demand for notes and bonds plunged to a new all time low for the month of May. Foreign demand in May has dropped from $46 billion per month in May 2010 to just $21 billion per month this May. The 12 month average of note and bond purchases by foreign accounts has dropped from $57 billion per month to $21 billion. This trend of weak and declining foreign buying remains a very bad sign for the Treasury market, and ultimately for the stock market. Without more foreign buying, yields will remain under upward pressure, and money will start getting sucked out of stocks as buyers pursue higher yielding, lower risk bonds.
If you hold maturing bonds, now would be a good time to take the cash and put it in short term Treasury bills as interest rates rise. Bonds will lose value in this environment until economic or market weakness forces the Fed to reverse course from tightness to ease. There will come a time to reinvest longer term, but it isn’t now, and it won’t be for the foreseeable future. Bond mutual funds will also get hit. I would sell them and move into T-bills.
The trends are clear, and with less and less money in the system, and more and more funding demand (Treasury supply) the money markets will begin to encourage, if not force, liquidation of stocks. My technical work on the markets suggest that this week is pivotal. Any breakdown in stocks will be a sign that the bear is about to really sink its teeth into this market. I’ve advised being out of the market, and I continue to recommend staying out.
If you want to profit from the coming decline, this would be a good time to either short the SPY or a basket of stocks, or to buy short term slightly in the money puts on the SPY or a basket of stocks, with at least 4-5 weeks until expiration, but not much more.
Put option purchases like this are an outright bet on the short term direction of the market. If you are buying puts, only bet an amount that you would be willing to lose, because if the market goes up in the short run, they can go to zero. But a broad based market decline could reap you multiples of your initial bet. Based on the supply demand trends in the fixed income markets, along with my technical work on stocks, I believe that now would be a good time to take that risk.
If you’re interested in the short side, you can look at our ideas here, or check out Shah Gilani’s put play research and recommendations in Zenith Trading Circle.