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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.
Urgent: Feds use obscure loophole to threaten retirees. If you have a 401(k), IRA, or any type of retirement account, this could cause you to miss out on $68,870 or more. Learn more…
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.
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.