Stocks and Bonds Are Finally Plummeting. Here’s How the Big Banks Are Pulling Some Strings

Demand for Treasuries at the weekly Treasury auctions has risen by slightly more than the increase in new issuance lately.

With more buying, which should boost price and push the yield down, why have Treasury yields been rising? Because selling in the secondary market has outstripped demand!

Securities prices, just like the prices of the everyday goods that we purchase in daily life, are driven by supply and demand. Money is the fuel of demand. Treasury debt is supply. In today’s markets, there’s more supply than there is demand.

In the big picture that I have been painting for you over the past year, the growth of money (what professional investors call “liquidity”) is waning and soon to turn negative, thanks to the Fed and its foreign central bank cohorts.

This is bad news not just for the Treasury market and bond market in general, but for stocks too. The bad news that we have been expecting is starting to happen.

But this bad news wouldn’t be apparent if it were not for the involvement of the Primary Dealers, the legion of big banks that the Fed works with.

That’s why today, I want to take a deep dive into how the involvement of the Primary Dealers is influencing this market downturn.

The Primary Dealers Are Required to Participate in Treasury Auctions. But There’s a Problem…

The Fed and Treasury require the Primary Dealers to participate in Treasury auctions, in return for the privilege of being the Fed’s exclusive counterparties in open market operations.

The problem for the dealers today is that weaker demand from other investor classes has forced them to take down more note and bond inventory than they otherwise would. Strangely and ominously, last month they took down more note and bond inventory, but they bought fewer T-bills. This could be a sign that they are running out of cash.

The market has persistently gone against the dealers over the past couple of years as they have increased their buying. An accident has been waiting to happen because of this. It looks like it started to happen in October, with stocks getting nailed.

Last week, with the stock market selling off, Treasury prices rallied and yields headed lower (price and yield are inverse). That could be a feature of the market when stocks get sold heavily, but yields should surge when stocks inevitably have a bigger short covering rally than the one-day affairs we have seen lately. We saw that in microcosm on Monday morning as stock prices surged and bond yields moved higher with them.

T bill issuance continued to soar in September as the government borrowed more and more money to cover the massive budget deficit. Normally dealer takedown moves with total supply, if not proportionately, at least directionally. But dealer takedown was flat in September.

That is alarming. Investment funds and foreign accounts took on more issuance at higher rates, but dealers didn’t. This raises the question of whether they are now in the cash squeeze that we’ve been expecting. It goes a long way toward explaining the increase in stock market volatility. We have believed that as the Fed pulls money out of the system, the dealers would be less able to maintain orderly markets. It appears that this is coming to pass.

I wrote on September 24, “Dealer liquidity is tightening as the Fed increases its cash withdrawals from the banking system under its balance sheet bloodletting, a.k.a. “normalization” program. The problem should worsen. In September, the ECB cuts its QE from €30 billion to €15 billion. In October the Fed’s monthly drains increase to $50 billion. That will cause the market to tighten even faster.”

That wasn’t a new warning of course.  I have been saying something similar for a long time.

I wrote on January 23, With the Fed increasing its draining operations through October of 2018, 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.

Now That Stocks Are Finally Declining, Here’s What You Can Do

With the summer rally intervening, clearly I was early. I don’t blame you for thinking that I was the “boy who cried ‘wolf!’ ”

But now, it’s happening.

The bottom line is this. If you haven’t prepared yet for what’s about to happen to the markets, you need to do it now.  You should be mostly out of stocks and long duration fixed income securities. With short term bill rates skyrocketing, this has been and will continue to be a great time to be holding and rolling T-bills.

And you can profit from stock market declines by buying puts on the SPY, the ETF that tracks the S&P 500, whenever the market rallies to resistance. I have been recommending buying the nearest in the money puts with about a month or 4 weeks until expiration, like it was doing on  Monday.  Keep a mental stop just above resistance to cut short any trade that goes against you. For example, as of Monday, that would be around 2730 on the S&P 500.

The markets are finally doing as expected, given the supply/demand fundamentals.   This could get a lot more violent as liquidity dries up.  I would expect the 10 year to eventually shoot past the recent peak of 3.25 and move toward 3.60 on the next spike. Short term bill rates will continue their rise, and stock prices will plunge in waves.

Remember, the Fed isn’t likely to step in until, in Chairman Pow’s words, a “significant and sustained” decline in the financial markets. Since he made those remarks at his September 26 press conference, other Fed mouthpieces have echoed them.  They’re talking about a bear market in stocks.

Sincerely,


Lee Adler

5 Responses to “Stocks and Bonds Are Finally Plummeting. Here’s How the Big Banks Are Pulling Some Strings”

  1. As for the “boy who cried wolf”, you are better to be early than much too late. Including today, the markets have been posting gains, which I see as a relief rally. When the next, almost inevitable rate hike is initiated along with the continued $50 billion Fed draining (QT), the markets are certain to be jolted. Lending rates will rise to well over 5% for home buyers and higher for auto loans- not good. If the Federal Reserve doesn’t follow through with an expected rate hike, will there be any longer term market gains, or are markets doomed to fall?

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