Federal Reserve Primary Dealer positions are poised to explode. They are bulging, bloated, and overstuffed. When they blow, the mess they’ll make will be epic.
The Primary Dealers are appointed by the Fed. The dealers get the exclusive privilege and responsibility of being the Fed’s sole counterparty in Open Market Operations. They also have the privilege and responsibility of being the Primary Dealers for the US Treasury in its weekly sales of US Government bills, notes and bonds. Their main business is the accumulation of bond inventories at wholesale prices and the distribution of those inventories to their institutional customers at marked up retail prices.
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Lately the dealers have been doing a lot of accumulating and little distributing, and that it isn’t by choice. For it is distribution that provides their profits. Forced accumulation is a responsibility that they’ve never had to deal with before.
They’re required to bid at Treasury auctions. Meanwhile, the Treasury is flooding the market with so much supply, the dealers end up with much of it. Maybe not as much as other types of buyers like domestic investment funds who are in a buying panic the likes of which the world has never seen. But the dealers are accumulating enormous positions nevertheless
They are groaning under the weight of their mushrooming bond portfolios. Their positions are way, way out of whack with historical norms. The next mushroom we see may be a mushroom cloud.
This post is excerpted and modified from Primary Dealer Positions Bulging, Bloated, and Overstuffed, Could Explode, at Lee Adler’s Liquidity Trader. You won’t see this kind of reporting and analysis anywhere else at any price. This post is just part of the full report. It does not include the investment strategy recommendation, and other important details, data, and analysis, that subscribers get in the full report.
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Federal Reserve Primary Dealer Positions Grow to Dangerous Record
Primary Dealers increased their Treasury coupon net long positions by $32.8 billion in the 4 weeks ended May 8. Positions are now virtually equal to the record highs reached at the end of January. And they have again gotten longer on a net basis vs. their futures hedges.
Unlike the “old days” under QE, the Fed isn’t backstopping these purchases. Back then the Fed was buying them or financing them the following week. Likewise, the Fed is no longer holding all of that newly issued inventory off the market. Much of this inventory is in dealer trading accounts and big leveraged speculator accounts. It can come back to the market at any time. This is an accident waiting to happen.
Dealer Hedging is Falling Short
The dealers hedge their cash bond positions in the futures markets. For the week ended May 14, 2019, dealer positions in Treasury coupon futures were net short approximately 895,000 contracts. They had a face value of $108 billion. That was up from $96 billion net short on April 10.
Considering both the futures and cash positions, their net long position would have been $157 billion in early May. That’s vs. $138 billion in mid April. They are still getting longer on a net basis. Their net longs are way up from just $5 billion in November and a previous high net long of just $34 billion in mid September 2018.
This doesn’t include their long positions in Agencies, MBS, and corporates. They were net long those by $110 billion as of May 8. That’s down slightly from $114 billion on April 10. But it pales in comparison to their $34 billion increase in Treasury coupon holdings.
Including all positions and futures hedges, the dealers would have been net long fixed income coupon securities by $257 billion in the second week of May. That’s up from $252 billion 4 weeks before.
No Help From The Fed!
Unlike under QE, the Fed is not buying any of this inventory. In fact, it’s exacerbating the problem by continuing to redeem its Treasury holdings. The Treasury needs to sell more paper to pay back the Fed.
The growing supply of Treasuries without help from the Fed shifts the burden of absorbing the paper to the dealers. Without the Fed cashing them out every week like it did under QE, the dealers must finance the purchases.
The result is increased dealer leverage. This creates systemic danger because if bond yields rise, the dealers’ losses would be multiplied.
This requires the dealers to do massive, and constantly increasing, hedging in futures. But that’s not happening. Dealers are reducing their hedges relative to the increases in their long positions.
As a result, the bond market could become increasingly unstable, with violent swings in both directions, but generally trending toward higher yields.
Leverage Driven Bond Rally Increases The Risk
The recent bond rally runs counter to that, which creates the likelihood of even greater instability ahead.
A massive increase in dealer repurchase agreement financing helped to drive the rally in long term Treasuries from November to February. Early this month that borrowing again rose to the late December record level. That helped drive the resumption of the Treasury rally.
Dealers would be ill prepared for an uptick in yields. The last time dealer repo was above $1.55 trillion, the 10-year yield rose 95 basis points in the ensuing 12 months. That culminated with dealers becoming unable to maintain orderly markets in either bonds or stocks. Today’s setup is just as ominous, if not more so.
Let the buyer beware!
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