I’ve always been a proponent of implementing reason in any endeavor, especially finance.
While we currently turn on our televisions or open our laptops and see a market driven by unwarranted bullish sentiment and growing terminal leverage, we must avoid our propensity to get drawn into the hype.
And we should remember that this hype is the final hot breath from the lungs of a rally, and a very bearish sign indeed.
So as I watch the stock market soar and the bond market teeter, the famous quote of philosopher George Santayana, comes to mind:
“Those who cannot remember the past are condemned to repeat it.”
And history reminds us to pay heed to the warnings of the forthcoming market decline.
At times like these, as the world descends into increased trade wars and political chaos, and as the working class becomes increasingly marginalized, we stand on a very dangerous edge.
We’re standing on an edge that parallels the world of 1929-1932, the time of the stock market crash, the Great Depression, and the rise of fascism, a period during which Santayana was still alive.
Some of us are paying attention and are worried. The rest merely fixate on stock prices and see nothing to worry about.
But my job is not philosophize about history. My job is to track and analyze the forces of liquidity, the bases of supply and demand for investment securities, and to draw conclusions from the trends that I see. That’s why I’m here to report my findings and observations to you.
I May Appear Wrong, but Liquidity Tells Us a Climax Is Approaching
I do not write these latest reports to you with joy in my heart.
These are anguished times, and this has been a deeply sobering lesson that, in the words of economist John Maynard Keynes, “the markets can remain irrational longer than we can remain solvent.”
In the short run, I may appear inaccurate about my prediction that the market will decline. Certainly since the February low in the stock market, it has looked that way. And it looks especially so today as the stock market breaks out through recent highs.
But I will continue to do my job reporting the facts about systemic liquidity to you. And I will continue to give you my best analysis of what those facts mean. This is part of an ongoing story. The buildup has been long and arduous, and continuing. A climax is approaching, and I believe that it will soon be upon us.
So now let’s look at the most recent data on the supply and demand for investment securities, particularly US Treasuries, because the bond market leads.
Treasury supply has been surging, thanks to the Trump tax cut, and increased spending under the Bipartisan Budget Agreement (BBA), or what I call the Budget Busting Agreement. And the Primary Dealers are responsible for taking down a significant portion of that issuance.
|Primary Dealers are investment dealers appointed by the Fed to have both responsibilities and special privileges in making markets. They include 7 US banks, among them Morgan Stanley, Merrill Lynch, J.P. Morgan, Goldman, Sachs, and Citigroup, and 16 other banks from around the world. They are the lynchpin of the US markets.It’s their job to be the Fed’s counterparty in the market, and the anointed primary correspondents with the US Treasury for auctions of Treasury paper.
Primary Dealers are the biggest market makers in everything – bonds, stocks, commodities, and derivatives. It’s their job to take in securities, mark them up, and sell them to their customers at retail.
When Primary Dealers are flush with cash they push prices higher with ease. When they’re not flush, they have greater difficulty in doing so.
And when central banks decide to pull the “punchbowl,” which really means to stop funding the dealers, prices fall. We get bear markets.
Click here for more information about how the primary dealers interact with the central banks…
Although the Fed was the “buyer of last resort” under the QE after the 2008 financial crisis from 2009 to 2014, it has resigned from that role. In fact, it instituted reverse QE, removing cash from the system, beginning in October 2017. It has been ratcheting up those removals every quarter and will do so again this October for the final time. At that point the Fed will be pulling $50 billion per month out of the banking system.
This has forced the Primary Dealers to take down more new issuance without the Fed backstopping them with endless cash. The Fed is forcing the dealers to take on additional supply at the same time as it is pulling cash from the system under its balance sheet “normalization” program.
This leaves the dealers with less and less cash, forcing them to borrow money to buy the additional Treasury issuance on margin.
Meanwhile the only class of investors giving them any help are investment funds. Auction data shows that foreigners are not helping. In fact, they’re running away. This adds up to bad news for bonds, and that’s ultimately bad news for stocks. But it is taking longer than I thought, thanks to speculators using more and more leverage to buy stocks, sending prices higher.
Treasury auction demand outstripped supply in the first half of July. The surge in demand helped support bond prices and keep the lid on yields this month. That demand surge is likely to prove temporary. Monday’s plunge in bond prices was probably just a warning shot, but an extended rise in yields is inevitable. Just as the rise in short term rates has been relentless, bond yields could look similar later this year.
T-bill issuance continued its upward climb in June as the government needed to borrow more and more money to cover the massive, growing budget deficit.
Dealer takedown slipped. Dealer liquidity is tightening as the Fed increases its cash withdrawals from the banking system under its balance sheet bloodletting program, which it calls “normalization.”
Investment fund demand for short term T-bills continues to soar. This increase in demand for short term bills illustrates the principle that as short term rates rise, investors will increasingly choose risk-off investments. As rates continue to rise, this will begin to suck cash out of the stock market.
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 June. That’s despite rates remaining negative in Europe and Japan. Some foreign money is clearly fleeing the US, despite rising rates.
Year to year gross Treasury coupon issuance surged in early July but dealer takedown has not kept pace. Foreign demand fell for the second straight year, reaching a new low for June. Investment funds have been picking up the slack. If they continue to do so, they’ll have less cash available to buy stocks.
This chart shows the surge in Treasury supply over the past year that has forced Primary Dealers to take down more of it. Unlike under the Fed’s QE program from 2009 to 2014, this has forced the dealers to be buyers without the Fed backstopping them with endless cash as the buyer of last resort. The Fed has forced the dealers to take on additional inventory of long term Treasury paper, at the same time as they have less cash. Their only option is to use margin borrowing, increasing their leverage.
|As an aside, a couple of readers have mentioned that huge waves of foreign buying are boosting the markets. This chart says otherwise. Demand from foreigners declined to a new all-time low for the month of June.
The longer the dealers are forced to buy, or willingly do so, the more dangerous the trend becomes. While they simultaneously have increased their futures hedges, the dealers are still net long Treasuries. They are not positioned for rising yields. The pain that mispositioning inflicts on the dealers is probably the reason behind so many pundits bleating for the Fed to slow or stop rate increases, and slow or stop the shrinkage of its balance sheet.
Meanwhile, the new sheriff in town, Jerome Jerry Jay Powell, isn’t showing any sympathy.
With Treasury supply steadily increasing, and cash in the system falling, eventually bond prices must fall and yields rise. Overleveraged dealers will be forced to liquidate. We know what happened when dealers were positioned wrong in 2008. Forget about 1929-32. Apparently, nobody learned that more recent lesson of history 2007-2009.
And don’t expect the commercial banks to take up the slack for the dealers. Their takedown of new issuance is too small to even register on the chart. Furthermore, they’re the ones seeing their deposit growth stall, thanks to the increasing Fed redemptions of Treasuries. As a result, the banks have shown themselves unwilling and/or unable to pick up any material part on the increase in Treasury supply.
What they have done instead, is to extend record credit to shadow banks and dealers. Despite this record financing of securities purchases, Treasury prices have barely held their own. Much of the increased financing has been diverted elsewhere, and that elsewhere has clearly been the stock market.
Source: Federal Reserve
This Won’t End Well for Investor Portfolios. Only the Timing Is in Question
The bond market has flirted recently with breaking secular trendlines going all the way back to the 1981 high in bond yields. When the10 year Treasury yield finally breaks out above 2.90, and ultimately 3.15, it’s likely to make a sustained move to much higher levels. Such a move would have a devastating impact on dealer liquidity, and financial market liquidity in general. Forced selling would run rampant. It would be a death knell for stocks. I expect disorderly declines in both stocks and bonds.
Under the circumstances, the correct strategy would be to hold T-bills, which will be increasingly rewarded, and get out of long term paper. Aggressive traders could short bond ETFs or buy inverse Treasury ETFs on a yield breakout. However, there’s little to be gained by being early. We’ll need to keep an eye on the bond market for technical indications of the time to go short.
Ditto for stocks. I’ve been too early on shorting the SPY, and our mental stops have been hit. But a low-risk reentry point is coming, and I’ll alert you when it comes.
Meanwhile, if you are looking for other trading ideas, long, short, or market neutral, check out my special collapse to profit/ collapse to protection report, or check out why Shah Gilani is “DONE WITH STOCKS” and how he’s making money anyways.