Back in December I had no idea that a pandemic was coming. I had no idea that COVID19 would cause Treasury supply to increase 10x. Nor did I know that the Fed would buy all of it at first, and then that it would experiment with cutting back until “who knows what.”
But that’s what happened, and that’s what the Fed has done and is doing. I was concerned about supply demand back then, but I had no clue how understated my concern would be. Here’s what I wrote 6 months back.
12/18/19 Primary Dealers continue to carry all-time record inventories of fixed income securities, far above their historically normal bond positions. They are not well hedged. They are overwhelmingly net long and they are massively leveraged…
Furthermore, with more and more Treasury supply constantly on the way, the Fed must keep buying and/or lending the cash to buy to its straw men the Primary Dealers indefinitely. The dealers and the market at large is in no position to absorb $100 billion a month in new Treasury supply.
So the Fed is now trapped. It can’t simply end Not QE without risking a massive system wide crash. It must continue to add cash to the market indefinitely. But can it continue to print endlessly without horrific unintended consequences?
And what will those consequences be? Endless asset bubbles to the sky? Increasing consumer inflation that ultimately leads to hyperinflation?
When the pandemic hit, the Fed at first was flummoxed. It had been printing since September when the money markets blew up, but it wasn’t printing enough. And it was slow to react. So stocks crashed. That’s when the Fed went into panic mode and began printing money as if there would be no tomorrow.
Let’s be clear about one thing. The Fed did not swing into action to rescue the US economy from depression. The Fed’s first order of business when the SHTF was to rescue the Primary Dealers. Which it definitely did.
The dealers were leveraged to the hilt with record long positions in Treasuries. The Treasury was already issuing a trillion a year in new supply. That forced the dealers into the position of having to buy and own mass quantities of US Treasuries. The pandemic meant that they got well paid for that because yields collapsed and Treasury prices soared as the world’s investors dumped stocks and headed for the perceived safety of Treasuries.
But dealers took it on the chin when stocks and all other assets crashed. There’s no question in my mind that they were down and out at that point. We may never know how bad things were. The Fed papered over their problems by buying a couple trillion of their Treasuries and MBS at record high prices.
But we may still find out just how bad things are. Because the dealers remain leveraged to the hilt. And there’s one more thing.
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