Here’s Why Primary Dealers Are Getting Buried, and That’s Bad for Us Too

Once upon a time, the US Treasury had to borrow a lot of money…

OK that’s all the time.  Unfortunately, now more than ever. And that’s a very big problem, despite the fact that it doesn’t looks so bad right now. After all, Treasuries have staged a massive rally for a month now. It’s all good, right?

Well, not so much.  Here’s why.

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Demand for Treasuries at the regular auctions has risen more than the increase in new issuance lately. Both stocks and bonds have rallied over the past week. Accompanying that has been a gigantic surge in bank buying, and lending by non-banks.

This doesn’t bode well for the sustainability of the rally. Banks have a poor record of market timing, and rallies driven by leverage, as opposed to cash, grow increasingly fragile.  

The problem for the Treasury market is that these stock liquidations come in waves. One of those waves has just ended. Within the next few weeks,  the underlying shortage of money liquidity relative to Treasury supply will reassert itself. Treasury prices will start falling and yields will start rising again.

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However, another plunge in stock prices could drive more Treasury demand. The markets remain very thin in both directions. Over the past 5 trading sessions the volatility has mostly been to the upside. But we can’t make a bet in that direction because of the underlying dynamics of the Fed pulling $50 billion per month out of the banking system. That exerts continuous drag, which will sap demand. Timing is the tricky part, which we must leave to technical analysis. I cover that for stocks in the Wall Street Examiner Pro Trader Market Updates and for bonds in the Treasury Market Updates

Meanwhile, Primary Dealers, the guys who essentially own and run the Wall Street casino, and who have special relationships with the Fed and Treasury, aren’t doing so well. 

Here’s what you need to know to avoid getting sick along with them.

The Dealers Are Getting Buried in Inventory

In the 4 weeks ended December 19 Primary Dealers massively increased their Treasury net long positions. The speed and size of the increase was extraordinary. The question is whether this was voluntary, or a kind of forced march under the onslaught of the massive supply increase. The special status conferred on the dealers by the Fed and Treasury means that they are required to bid.

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For a change, the market gave them a break, as it rallied from 2 year price lows. The selloff in stocks triggered a buying panic in bonds. 

But the last massive breakout like this led to an all-time low in bond yields in 2012, followed by a reversal to 3% in the 10 year a year later. If the dealers are on the wrong side of this, as they always have been at major turning points, we could be looking at 4.5% to 5% this time next year.

As Treasury supply has surged, the dealers have taken down more of it. At the same time, they have not had the Fed as a buyer of last resort since the Fed ended QE. The Fed is now pulling $50 billion per month out of the banking system, reducing systemic liquidity. Meanwhile, dealer inventory, the main potential source of liquidity, is mushrooming. The buildup of energy could turn into a mushroom cloud of destruction.

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The Fed has literally been forcing the dealers to hold more paper and less cash. The dealers can raise cash by using the T-bills as repo collateral, and have, but that only increases their leverage ratios, and therefore risk. Ultimately, this should be lethal for the markets. It’s difficult to see this somehow unwinding in an orderly way.   

I have been reporting this pressure on the dealers all year. It’s no surprise that the big bank parent companies of the Primary Dealers, have performed so miserably. The dealers have been forced to absorb trading losses because of their responsibility to absorb their share of the offerings. The excess liquidity that had enabled them to maintain tight spreads is gone. They have little cash cushion. This has decimated their ability to maintain orderly markets.

It shows up mostly in stocks and lower quality fixed income markets. Bid-ask spreads widen, and we get wild volatility in both directions.  But it has also shown up in the stock prices of the big banks.

The Pressure On Dealers Is Increasing, and Risk To The Market Along With It

And now that the dealers are even more massively long, they are at even greater risk, and that puts us at even greater risk.

The dealers hedge their cash bond positions in the futures markets. For the week ended

December 18, 2018, (last report before the government shutdown) dealer positions in Treasury coupon futures of all durations were net short approximately 1.3 million contracts with a face value of $146 billion. That was an increase of $5 billion from the $141 billion net short in mid November. Their futures short positions have been soaring as they’ve been forced to take on more and more cash Treasury paper.

But, and this is a big “but,” including both the futures and cash positions, the surge in their cash holdings meant that on balance the dealers increased their net long position to $58 billion in mid December, up from $5 billion 4 weeks before.  

The dealers were also net long throughout the big selloff in bonds And that doesn’t include their big long positions in Agencies, MBS, and corporates. The rally of the past month helps them recoup some of the losses from the prior bond selloff. But it’s a drop in the bucket, and with more and more supply on the way, and less and less cash available to absorb it, this rally is doomed. 

That does not mean that we know when it will end. We’ll let the technical analysis tell us. In the meantime, I continue to recommend avoiding bonds and holding T-bills. I would hold bills of 13 weeks to 1 year duration in a Treasury Direct account, and roll them over at expiration. As an alternative, holding a government only money market fund would be satisfactory. 

Start the countdown: By next month, you could be sitting on a $15,000 profit.


Lee Adler

4 Responses to “Here’s Why Primary Dealers Are Getting Buried, and That’s Bad for Us Too”

  1. William P. Dunn IV

    Lee you got this one right. For many what you wrote may seem a bit complicated, however as a 20 year former employed participant in the Primary Dealers community you hit a grand slam. Back in the late 1980’s there were 55 dealers today it’s 60% less. Technology has changed the game somewhat, fundamentals however do not change. The primary benefit back in the hay days was a positive cost of carry and a long term downward bias to declining interest rates. The bottom was June 2016, the Ten year note hit 1.39%. Trillion dollar defects for the next few years in a non recessionary and good economy will put upward pressure on rates. Numbers don’t lie only STUPID politicians to the mass of idiot voters do. At some future point the rate rise is inevitable, could be 6 months out or later but it will come to pass. William P. Dunn IV

  2. Lee,
    Buying 13 week T-bills today is this a good idea, or did the 13 week t -bill go into negative territory ?
    If it did fall into negative territory, does that effect the 13 wk T-bill in Treasury
    Direct also ? Is it wise to buy 13 wk T bill Now or do we wait ? Is the 13 wk t bill safe for cash money?
    thanks so much !

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