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The stock and bond markets face a triple whammy at the end of this month. In this report I’ll show you what those three things are, why and how they will impact the market and what you should do about it (subscriber version only). These three things coming together as soon as xxxxxx (subscriber version only) will pose a grave threat to the Treasury market, to short term interest rates, and ultimately to the stock market.
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The Treasury is rapidly exhausting its cash as it continues to pay down T-bills. At this rate, it will run out of cash xxx xxxx xxxx xxxx (in subscriber report). Congress will then be forced to raise the debt ceiling.
The Treasury will need to issue immense amounts of new debt to repay the internal accounts it raided, and to rebuild its cash account to the TBAC recommended level of $400 billion.
For the past month, and until the debt ceiling is lifted, Fed QE has been covering and will cover 100% of new Treasury issuance. That’s a short term bullish factor for bonds and stocks as it keeps pumping cash into the dealer and other institutional accounts that had been the holders of the T-bills being redeemed.
In fact, it’s surprising that the stock rally has been so muted, and that the bond rally has stopped in its tracks over the past 6 weeks. That’s because corporations have been rushing to issue new equity and new debt to take advantage of the high prices they can get. This is free money to them.
Once the Treasury begins to issue new debt, it will be on top of this gigantic wave of corporate supply. It won’t be pretty.
It also won’t be immediate. I estimate that by the time the debt ceiling is lifted and the Treasury supply tsunami starts, the Fed’s RRP slush fund will reach xxxx (subscribers only). That’s how much new Treasury debt can be issued before the crisis becomes apparent.
We have some time. And we have the meters of the Fed’s RRP slush fund account, and the schedule of new Treasury issuance, as well as the QE schedule. If the Fed chooses to reduce that schedule, that’s their problem, and the market’s.
But it won’t be ours. Because we’ll be actively watching, with situational awareness. We’ll be prepared to take advantage with enough advance notice to act accordingly. Here’s our current situational awareness update.
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This is a repost of the previous post, with corrected headline and link. I apologize for the redundancy.
Primary dealers have offset their losses of last August through February in the recent rally, and they have reduced their net long exposure somewhat since their highest levels of a year ago.
But that doesn’t mean that they’re not still at significant risk if the bond market begins to selloff. They are still positioned for stable or higher prices, and stable or lower yields. If yields rise and Treasury prices fall, as I have concluded they will, then it won’t be long before the dealers are in trouble again. And if they’re in trouble, all asset markets will be in trouble.
This report looks at the particulars of their positions, along with a quick update on the 10 year Treasury yield. That includes a few keys that should signal when the next decline in bond prices is starting.
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Treasuries have sold off on the strong, surprise jobs report last week.
At the same time, there’s been an equally important, but less well known surprise. The Treasury has maintained an increased pace of T-bill paydowns in the first third of August, despite the re-imposed debt ceiling.
That’s a short term bullish factor for bonds as it keeps pumping cash into the dealer and other institutional accounts that had been the holders of the T-bills being redeemed.
But it also means that the Treasury will spend its cash faster than I had initially imagined. That means that the bullish influence will end sooner than in my last guess.
I use the word “guess” deliberately. It’s difficult to estimate of what brilliant, but crazy, policymakers will make up when the heat is on.
The good news is that we now have evidence of a pattern. That pattern shows a fast spenddown. At this rate of spending, the Treasury will run out of cash in xxx xxxx (in subscriber report). As I recall from the past 7 debt ceiling debacles, there’s also a legal mandate that the government must make a large military pension fund contribution at the end of the fiscal year which will affect the drop dead date.
Maybe they can delay that for xxxx xxx xxxx (subscriber report) depending on the strength of mid September quarterly income tax collections. But at some point in xxxxxxx, the pressure to raise the debt ceiling will force a deal.
The jobs data was a surprise. As usual, the BLS first release is BS. The July nonfarm payrolls report grossly overstates the increase in jobs. The tax data is actual and, as I pointed out in the monthly Federal revenues report posted last week, withholding tax collections show that the payroll gains were certainly less robust than the BLS said they were.
As you may recall, back in the spring, there were a couple of months were the nonfarm payrolls gains were severely underreported relative to what the withholding tax collections were showing. I wrote then that the BLS data would catch up to the reality within a few months. I believe that the July report was the “catchup” month.
In our report on July federal withholding collections, we saw a dip in the second half of the month that suggested that the economy had fallen off a cliff. But withholding has now recovered to the trend in force since mid May (CHART in subscriber report). It is now at an inflection point where it should signal whether the economy has gotten back on track, or is in the process of rolling over. This should happen over the remainder of this month. I’ll post an updated chart when it happens.
The Wall Street talking head community, with a few Fedheads chiming in, is now in a growing chorus that the Fed will start tapering soon. Our analysis has been that the Fed can only taper if the Federal deficit is shrinking, thereby reducing Treasury supply. If the Fed were to taper in the face of constant or rising supply, the market would need to adjust in order to absorb the additional supply. Bond prices would fall and yields would rise.
This is where the revenue trend is important. If it weakens, the deficit will grow and supply will increase. This is even before considering the $1 trillion infrastructure spending package. If revenue growth stays strong, the Fed could conceivably do a small cut in QE (aka taper) without crushing the bond market. That could turn into the muddle through scenario.
The Treasury market rally of recent months has meant that Primary Dealers have built a profit cushion that would provide some protection in the event of bond market price weakness. In addition, initially, the supply increase that results from the lifting of the debt ceiling will be funded by the trillion + dollars that has been deposited in the Fed’s RRP program. That is still growing as the Treasury continues to pay down T-bills.
Those two factors will delay a bond market crisis for xxx xxxx (subscriber report).
It depends on when the debt ceiling is lifted, how much tax revenue the US economy is generating, and how much the Fed cuts its purchases of Treasuries and MBS as it begins the “taper.”
A muddle through scenario is always possible, but a crisis is also possible, if not more likely. The timing is in question, but it should come xxx xxxx xxxx xxxx (in subscriber report). The timing will become clearer as the trends of the data begin to show themselves once the debt ceiling is lifted. That includes the supply schedule, the trend of Federal revenue, and the Fed’s schedule of reduced purchases.
In the meantime, the status quo rules. As long as the Treasury is using its cash to pay down t-bills, the uptrend in stocks should continue. The selloff in Treasuries over the past week should reverse as those paydowns continue.
See the full report for the charts, more details on the supporting data and how we arrive at these conclusions, along with the timing, and an idea of the appropriate strategy under these conditions.
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Wall Street wiseguys and the mouthpieces of the Mob @CNBC and @WSJ don’t know it yet, but the US economy went over a cliff in the last two weeks. They don’t know because they’re not tracking the real time Federal tax collection data like we are. And that data shows us that’s what happened.
Here’s the data, what it means for the market and for us, and some suggestions on how we might view it and use it to possibly profit in the short run, and protect ourselves in the longer term. There are an unusual number of variables, unknowns, and yet to be knowns in this outlook, but we have a general idea of a couple of likely scenarios on how the next few months might unfold. If you want to avoid the catastrophe that lies ahead, it behooves you to be familiar with those scenarios, and to track the variables as they become known.
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Intro
The Fed has bought mass quantities of Treasuries and MBS over the past dozen years, in what are called Permanent Open Market Operations or POMO. This is just a fancy name for trading with Primary Dealers. We call the Fed’s massive asset purchases Quantitative Easing, or QE. The Fed buys that paper strictly from Primary Dealers with rare exceptions. The dealers then use the cash to buy more paper, whether more Treasuries, MBS, stocks, or other financial instruments.
QE has become the primary source of demand for absorbing the supply of financial assets. The primary source of supply is the US Treasury which has lately been issuing an average of $200 billion per month, or more, of Treasury debt. The market must absorb that. In the absence of QE, prices would be under constant downward pressure. Since stocks and bonds are to some extent interchangeable financial assets, both asset classes would be affected.
The Fed has made sure to print enough money, that is to pump enough cash into the accounts of Primary Dealers, to ensure that prices maintain a steady upward course. The Fed has made sure to engineer QE to all but guarantee bull markets in stocks and bonds.
At some point that could change, and we watch the data carefully in order to estimate when that’s likely to happen.
The QE vs. Supply Equation
QE has thus become the primary fuel that powers demand for financial assets.
The flow of QE cash to the Primary Dealers is almost steady, with a non-material reduction in MBS purchase settlements scheduled for mid month. Meanwhile, Treasury supply, to this point has been steadily enormous, fluctuating within a semi predictable range month to month. Not much has changed since the Fed’s pandemic emergency phase of QE began in March of 2020.
Until now. The big change is that the Federal debt ceiling is now back in force, which means that Treasury issuance will first slow, and possibly stop, until Congress raises the debt limit. This will reduce new Treasury issuance. Supply will be constricted. The reduction in supply could give the bond market rally a second wind, or it could accrue to stocks, or both.
So it will be bullish for awhile. Then it will stop. Then we’ll have a Wile E. Coyote moment. And then it will end. Badly. Here’s the how, why, and the timing.
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They’ve been threatening to do it for two years, and finally pulled the trigger. The Fed’s captured media barely gave it lip service, with a brief mention here and there. A sharp eyed Liquidity Trader subscriber, Chet, called my attention to this well hidden tidbit yesterday.
Here’s the relevant part of yesterday’s announcement by the NY Fed.
Under the SRF, the FOMC directed the Open Market Trading Desk (the Desk) at the Federal Reserve Bank of New York to conduct overnight repo operations with a minimum bid rate of 0.25 percent and with an aggregate operation limit of $500 billion, effective July 29, 2021. As with the Desk’s existing repo operations, the SRF will be cleared and settled on the tri-party repo platform. Treasury, agency debt, and agency mortgage-backed securities will continue to be accepted. All other terms will be the same as the existing overnight repo operations.
Primary dealers will continue to be counterparties for repo operations under the SRF. The SRF counterparties will be expanded to include additional depository institutions.
Chet wrote:
Why do they need this? Are the money markets who normally participate in the private repo market perceiving counter party risk? Even if the collateral they get overnight or term is pristine?I am watching all the CNBC talking heads right now, they don’t have a clue. They should be reading your newsletter on Macro Liquidity.
Without Chet, I may have missed that Fed release. It was not part of the FOMC statement, but was noted in a separate release at the same time as the usual Fed statement. It was designed to either be ignored, or at least under emphasized.
In that, they succeeded. Did anyone ask about it at the press conference? Yes, Mike Derby of the Journal asked a one line throwaway about it, and Powell gave a throwaway answer:
Derby: So I wanted to ask you about the standing repo facility and get your sense of what you think it will do for market trading conditions.
Powell: So, on the standing repo facility, what is it going to do? So it really is a backstop. So it’s set at 25 basis points so out of the money, and it’s there to help address pressures in money market — money markets that could impede the effective implementation of monetary policy. So, really, it’s to support the function of — functioning of monetary policy and its effectiveness. That’s the purpose of it. And it’s set up with that purpose in mind.
What a useless crock of shit that answer was.
I had not given much thought to the SRF recently, because I have always felt it was a non-issue. The Fed has always made unlimited amounts of repo funding available on an ad hoc basis when crisis demanded, so why would this matter?
Chet’s question made me revisit my thinking and I sent him this response.
I’ve long said that the idea for a Standing Repo Facility is smoke and mirrors. What’s the difference between it and offering them on an ad hoc basis when required, as they’ve always done? But I think I see their rationale for it. And it’s not what they say it is, of course.
Right now, there’s too much cash in the system from the Treasury paydowns, so it’s currently a moot point. But when that cash is gone in a few months, if the Fed opts not to take up the additional Treasury supply by increasing QE to absorb it, then the dealers will need to resort to repo to finance it.
[Additional note: Otherwise bond prices would fall and yields would rise.]
I guess the difference is that if they call it a “standing” facility, that means permanent. And that’s almost as good as outright QE to the dealers [because they would never have to pay it back], except that the cost would be variable, and would rise, if the market tightens.
Another thought is that by having this, it gives the Fed the backstop it needs to pretend to taper QE [emphasis added]. No question that something will be required to absorb the Treasury issuance. If it’s not outright QE, then it will be the SRF.
At this point the SRF is a non-issue. If they ever start to use it, we’ll have to see if the dealers redeploy enough of it to keep the markets levitated. As I said in the Lindsay Williams podcast interview (Bond Yields Down, Inflation Up, Here’s Why), there are simply too many variables that will come into play beyond the next 3-4 months to make an accurate forecast [beyond that length of time] now.
Thanks for alerting me to this! I wasn’t paying attention at all today. I was out exploring Warsaw!
To sum up, there’s currently no need for this facility. But when the Treasury runs out of cash (timing analyzed here) Congress will raise or suspend the debt ceiling, and the Treasury will start issuing more debt. If the Fed wants to keep bond yields down, it will need to buy more of that new debt, or fund it in some other way. There’s no way it could taper its purchases if it wants to hold yields stable. If it doesn’t buy more paper, then they hope that the SRF will do the trick.
If it doesn’t they would either have to let Treasury prices fall, and yields rise, up to a point. That point is the level that triggers a crash. You can forget about the Fed ever tapering purchases other than a token show trial for a month or two. To seriously reduce their purchases would be an act of financial mass murder.
They will either need to increase their purchases (more QE whoopee) or do repo, lots and lots of repo. The $500 billion they have initially set will be gone in a few months. Then they’ll go to a trillion, then who knows.
It’s all so sordid. But I’m not here to moralize about why this is so gat-danged wrong. We’re only interested in the practical effects of Fed policy on the prices of stocks and bonds. I analyze that and give you the look ahead for the time frame that’s reasonably foreseeable in the Liquidity Trader Money Trends reports. If you are a new subscriber, you can try them risk free for 90 days.
I could just repost the same thing every time I update this report. The Fed continues to rig the stock market, and that rigging continues to work. I know of no reason to expect this to change. Someday, it will, but not today. Make no mistake though, changes are coming, and you need to be ready for them. This report tells you what to look for.
Stock prices remain right in the middle of the channel surrounding the liquidity line on the Composite Liquidity Chart. What I wrote about this indicator in June, remains true today. The market isn’t overbought. Nor is it oversold. It’s just tracking the growth of systemic liquidity. Not too hot, not too cold, but just right. Goldilocks.
Earlier, in March, I wrote:
This indicator is so good that it looks rigged. If you’ve been with me for a long time, you’ve watched this with amazement, as I have, for years. When all these liquidity measures are combined into one, they form a track that stock prices mimic, and vice versa.
They are both cause and effect. It’s like quantum mechanics. They’re intertwined, separate, but one. Increasing liquidity causes stock prices to inflate. Inflation in stock prices causes liquidity to increase. The Fed just keeps pumping the fuel to make sure that the engine keeps running. And when it threatens to stop, the Fed just pumps more. It has had the ability to reflate the system when it has deflated.
Meanwhile, the US Treasury is acting as the paramedic rescue squad for now. It has been pumping massive amounts of cash into the money markets every week since February 23. It has been doing it with T-bill paydowns, which I’ve written about both in these reports, and in occasional news updates in the Wall Street Examiner.
Jaysus and Janet both are praying that those dealers and investors use that cash to buy enough longer term paper to push bond prices up, and yields back down. Keep in mind that yields are just the sideshow. The problem is that bond prices have fallen so much that dealers are facing enormous losses in their bond inventories. It renders them unable to maintain orderly markets in all their businesses.
Now $700 billion in T-bill paydowns later, on top of regular ongoing Fed QE, the Fed and Treasury have succeeded in driving a massive rally in Treasuries. That has given the Primary Dealers juicy profits over the past few months.
This has taken the pressure off the Dealers, who matter to the Fed, and transferred it to any hedge funds who were short Treasuries. If they lose money, the Fed doesn’t care so much, as long as the biggest ones aren’t at risk of going bust.
But the dealers must be saved at any cost, and for now, they have been. Once again, the Fed has managed to steer the market away from sure catastrophe. But this time, it took a partnership with the US Treasury, in the form of those massive T-bill paydowns pumping cash into the market. However, that’s a one shot deal. Once that cash is gone, it’s gone. And with the Federal debt ceiling back in place as of August 1, that cash will be gone, and soon.
There are a couple of likely scenarios ahead as the market faces the reimposition of the debt limit. Here are the most likely scenarios, along with how the Fed and Treasury are likely to manage the liquidity pool. Finally, as we track the flows in the weeks ahead, we’ll know what to do to manage our portfolios to take advantage, or to protect ourselves from the market crash that would be baked in if the Congress and the Primary Dealers behave in a certain way.
Or whether a muddle through scenario might play out.
I spell all of that out for you in this report.
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We’ve been following the story of the US Treasury paying down outstanding T-bills since late February. $680 billion of paydowns led to a big turnaround and rally in longer term Treasuries as the Treasury pumped that money into the accounts of former bill holders and simultaneously removed that paper from the market. Some holders sought greener pastures in longer term paper, leading to the rally in the 10 year yield and other maturities.
In recent weeks we’ve taken note of the Treasury reducing those paydowns, and we saw a few hiccups on the Treasury market. But over the past week, the rally resumed, thanks to this being the Fed’s monthly MBS purchase settlement week. Then the Treasury piled on again on Thursday, announcing another $48 billion in bill paydowns for this week.
The Fed holds MBS settlements in the third week of every month, for forward purchase contracts it made over the past two months. This week’s settlements total $128 billion, which is yooge. They started last Wednesday (July 14) with a down payment of $83 billion. The second installment is for $15 billion today. They finish up on Wednesday, injecting another $29 billion into the accounts of the Primary Dealers from whom they buy that paper.
Then late last week, the Treasury announced, in its infinite wisdom, that it would pay down another $40 billion in T-bills tomorrow (July 20) and $8 billion on Thursday. Drowning in cash, enough fixed income guys turned blue and bought further out on the curve on Friday and this morning to send bond prices soaring and yields crashing.
Apparently the dealers and others have wanted nothing to do with stocks, so they ploughed all of the cash into Treasuries. The stock selloff exacerbated the yield rally, and vice versa.
Traders and pundits tend to talk rotation when these events occur. For now, they’re blaming a resurgence of COVID cases, which is unwarranted because with a majority of US and European citizens at least partially vaccinated, few people are dying. It’s just mindless panic.
But here’s where Treasuries are really headed, and why. And what you should do about it.
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I finished my two dose vaccination regimen on June 14, and travel restrictions have lifted here in Europe since July 1. It’s been an interesting few weeks as I’ve made my way from my recent base in Zadar, Croatia, up through wonderful Ljubljana Slovenia, Bratislava Slovakia, and currently, the amazing city of Krakow Poland. I’ll be heading to Warsaw on Thursday, where I plan to hang out for at least a couple of months this summer as I do genealogical roots and look for evidence of family left behind here after my grandparents left in 1900.
As I return from vacation mode and a light publication schedule, I had a big day planned for tomorrow. I’ll be visiting Auschwitz all day. Therefore, I wanted to get at least a short overview of the current QE situation out to you tonight. This report covers the most important basics and outlook.
We already know that the bond market has rallied as a result of the massive Treasury paydowns. That’s all about to end, and I think that the Treasury rally may be in the process of reversing.
All good things come to an end. Here’s what to expect in the weeks ahead as a result of the things we already know, and a few that we can deduce as a result.
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Lee Adler