Author: Lee Adler

In Part 1 of this report, I covered dealer positions, financing, and hedging.  Dealers have mitigated a significant amount of risk by selling paper to the Fed, reducing their inventories, and increasing their hedges. They’ve also benefitted from the rally in prices over the past few weeks. That rally has largely been driven by the Treasury paying down T-bills.

This report looks at several large bank measures, including net unrealized profits or losses of large banks on trading positions, and week to week changes in total bank capital. Those changes indicate the profits of the entire banking system, or in this case, the 25 largest US banks.

The data suggests that the big banks who are largely the parent firms of the primary dealers, haven’t been as profitable as their earnings report suggest, or that at least they have not increased their capital at all.

They aren’t required to mark their investment portfolios of long term bonds to market. If they need to liquidate any of that, then those losses will be recognized. There’s some chance that they will need to liquidate later in the year, as Treasury supply increases, putting downward pressure on bond prices.

Meanwhile, Treasury paydowns will continue to support a bid for both bonds and stocks, for as long as they continue. Rip roaring tax collections have slowed the drawdown in the Treasury balance, so the paydowns will probably continue at their current pace, if not more, until xxxx (see subscriber report)

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Despite the weakness in stocks and bonds in the wake of today’s FOMC announcement, these conditions argue for the churning slight uptrends in stock and bond prices to continue until xxxx. Conditons will then turn more bearish. I tell you when that will be, and what my strategy is.

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For several months, I’ve been positing the idea that when the Treasury gets its cash level down to the legally required limit, the stock and bond markets would be in big trouble. The risk of a crash would be as great as it ever is. I posted an expected time window (in subscriber version)  where it would be a good time to get out of both the stock and bond markets.

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That conclusion came from the idea that:

• Primary Dealers were overleveraged in their fixed income portfolios.

• That the market has been artificially buoyed by the Treasury paying down T-bills. It has now injected $620 billion into the accounts of dealers and investors since February 23.

• That when the Treasury reaches the required cash level of XXX billion (reported in subscriber report), the paydowns will stop.

• That record levels of deficit spending would then no longer be partly funded out of the Treasury’s cash on hand. That would require a dramatic increase in debt issuance.

At first I estimated that that would happen in xxxx (see subscriber version), but lately I’ve pushed that estimate back to xxxx (subscriber version). At that point, the increase in Treasury debt supply would supposedly begin to push bond prices down both in Treasuries, MBS, and corporates.

Highly leveraged dealers would then face forced selling as they were required to meet collateral calls on the inventories they had financed with repurchase agreements (repos). Repos are just a fancy kind of short term borrowing to finance securities purchases, similar to when we use margin debt to buy stocks.

All of that still looks likely to happen. But instead of a crash, I can now see the possible outline of more of a “muddle-through” scenario. I still expect trouble to arrive around xxxxx (in subscriber version), with maybe a few weeks of Wile E. Coyote market action.

But maybe that trouble won’t be quite as bad as I first thought.

There are two reasons for that. Discussion in subscriber version.

The end of Treasury paydowns will, no doubt, cause yields to rise over a short period of time. And that could have been catastrophic.

But lo and behold, we see Primary Dealer data that suggests it won’t be as bad as I had feared. I show that data in a couple of tables and charts in this report.

We won’t know for sure until we get there. I’m still looking at xxxx (in subscriber report) as a likely top in the markets. We’ll just have to see how conditions evolve over the next (time period in report), and take action accordingly. For now, while the Treasury continues to pay down outstanding T-bills, we can follow this strategy (discussed in report).

Subscribers, click here to download the report.`

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KNOW WHAT’S HAPPENING NOW, before the Street does, read Lee Adler’s Liquidity Trader risk free for 90 days!

Act on real-time reality!

FREE REPORT – Proof of How QE Works – Fed to Primary Dealers, to Markets, To Money