The Fed Just Stabbed Its "Silent Partners" in the Back, and You're Next

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I've gone into detail elsewhere about the Fed's "silent partners," the primary dealers - big banks that have special status to act as intermediaries in the market where the U.S. government sells debt to raise funding for government activities. This is the government securities market, commonly known as the Treasury market.

The primary dealers are the conduits through which the Fed executes monetary policy. They're very loyal friends to the Fed and the U.S. Treasury, and they talk to them all day long.

Well, no good deed goes unpunished...

Right now, the primary dealers are in big trouble (thanks to a dastardly move on the part of the Fed).

And that means you (specifically, your portfolio) are in trouble too.

Here's what's happening and how to protect yourself.

The Fed's New "Treasury Flood" Will Be Lethal for Primary Dealers

We've already covered the fact that the supply of Treasuries will increase in 2018 as a result of the tax cut package and the fact that the Treasury needs to sell new debt to raise the cash to pay off the Fed when it redeems holdings under its program to shrink its balance sheet.

Meanwhile, the demand for Treasuries has been declining. This is a lethal combination for the bond market. We've been expecting this for months, and we've recently started to see the impact in the market as bond yields have surged and look poised to go higher.

One of the most important factors in this has been the fact that the primary dealers have been mispositioned for months. They are suffering losses as a result. A similar process occurred in 2008 when the dealers were positioned wrong. That mispositioning either caused or exacerbated the financial crisis.

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Declining investment demand has yet to be felt in stock prices. That's partly due to the increasing use of extreme speculative leverage as covered in the Treasury Supply report. But it is also because some sellers of bonds have been rotating into stocks.

That can work for a while, but eventually the impact of losses in the bond market, particularly dealer losses, will begin to take a toll on stocks. Rising bond yields will increase the pressure as some investors begin to opt for yield instead of the risk of holding stocks at these levels. I would view the first reversal in stock prices as the beginning of the end, an end that could come more quickly than most people think thanks to Fed tightening and mispositioned dealers.

Primary dealers sharply reduced their Treasury coupon long positions in the four weeks ended Jan. 10. They also significantly cut their other fixed-income positions primarily via a big drop in corporate holdings. The Fed has told them that it will redeem Treasuries and allow the paydown of mortgage-backed securities at an increasing clip through next October. That means that the Treasury will need to increase issuance to pay back the Fed. Considering that the Fed won't be helping the dealers to absorb the additional supply, it has the makings of a real problem.

Dealers have maintained large long positions in Treasuries for the past two years. Their net Treasury positions have been at or near the trendline connecting peaks going back to 2012. Twice before, reaching that level was followed by a big sell-off in bonds within six months. We already saw one big sell-off in 2016. Now it appears that a second wave of selling has begun, driving bond prices down and bond yields up.

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Dealers are not positioned to absorb an increase in Treasury supply, nor do they appear to be positioned for declines in bond prices. They are still very long Treasuries. Expect them to report more trading losses. That will only put more downward pressure on prices, upward on yields.

The dealers hedge their cash bond positions in the futures markets. For the week ended Jan. 16, 2018, dealer positions in Treasury coupon futures of all durations were net short approximately 408,000 contracts, with a face value of $40.8 billion. That compares with $45 billion net short in mid-December. The dealers sharply cut back their long positions in the coupons over this period while reducing their short hedges by a lesser amount.

So on a net basis, they got longer, betting on rising prices and falling yields. They have been wrong, just as they have been at every past major turning point. It is that very mispositioning that drives the trend reversal. As dealers are forced to sell their long positions, it contributes to the price drop.

On balance, considering both the futures and cash positions, the dealers were net long Treasuries by approximately $32 billion, which was down from $35 billion net long in December.

But this was up from $1 billion net short in early September. The dealers have been going the wrong way. Once again they are taking a hit, as they did in 2008 when they were positioned wrong. That contributed to the 2008-09 financial crisis. Dealer mispositioning and trading losses could again be a catalyst for the next crisis.

The dealers are obviously not positioned to accumulate the significant amounts of the new supply that they would need to, to keep prices from falling and yields from rising. I expect these pressures to begin to spill into stocks within the next couple of months as the Fed ratchets up its operations to shrink its balance sheet and drain funds from the financial system.

Get Out of Stocks Before the Bond Meltup Starts to Drain Your Portfolio

The bottom line is that while the stock market has gone crazy on the upside, bonds are doing exactly what we expected. It was the right call for the right reasons.

While stocks have gone parabolic, they've done so through increased leverage, not a rising sea of liquidity. That sea is diminishing. It can no longer support bull moves in both stocks and bonds.

The rotation out of bonds and into stocks is running against a constantly shrinking flow of money into the financial markets. Eventually, falling bond prices and rising yields will present stiff competition for stocks. I can't pinpoint exactly when "eventually," but the time is drawing close. I'll stick to my forecast that it will happen by the end of the first quarter or shortly thereafter.

Therefore I continue to recommend a systematic program of selling stocks to raise cash, with the goal of reaching 60% to 70% cash (more or less according to your personal situation) by the end of January if you started selling back in September, when I first proposed the idea. If you got a later start, I'd want to reach that goal by the end of March.

Meanwhile, stay tuned here for regular updates on the liquidity picture and for future trading recommendations to take advantage of tightening monetary conditions. I have already  made a "set it and forget it" pick for the long term. Get that special report here. If you are an active trader, follow my swing trade picks, both long and short, at the Wall Street Examiner.

Up Next: Rare Gold Anomaly

Money Morning Executive Editor Bill Patalon just caught something on his gold charts that he's only seen twice in the past 20 years. A $13 billion gold anomaly he calls the "Halley's Comet of investing."

It's very rare, and fleeting, and Bill sees things lining up perfectly to bring some very sizable precious metal profits to well-positioned investors.

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The post The Fed Just Stabbed Its "Silent Partners" In The Back - and You're Next appeared first on Lee Adler's Sure Money.

About the Author

Financial Analyst, 50-year charting expert, finance + real estate pro, and market analyst; published and edited the Wall Street Examiner since 2000.

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