Correction: In paragraph 4 I have corrected the line about the dealers’ net position to “net long.” In the original version I inadvertently wrote “net short.” That was an error. Sorry for the confusion!
The Fed provides us with a tremendous amount of information and data. Some of it is highly useful. Most is not, from my perspective of trying to figure out how it will influence, or even to some extent control, market direction.
One area of useful information is the data that the New York Fed publishes every week with a 9 day lag on Primary Dealer positions and financing. The dealers run the markets, after all, so it’s good to have some insight into their positioning and leverage. It can, at times, give us a heads up that trouble may be brewing. We saw that over the past year as the dealers began to reduce their massive, and massively leveraged, fixed income portfolios.
I have pointed out that that was a huge problem, because a decline in bond prices could put them under water again, just as during the pandemic panic of March 2020. The problem was so big then that the even more massive Fed bailout looked as though it wasn’t working for about 8 days. Then it did work, and the market turned. But it was a close call.
In recent months we saw the decline in the dealers bond positions, but they were still net long and still leveraged. I warned that as bond prices fell and yields rose, their profits would be pressured, and if it continued, their capital could be wiped out again.
The dealers are really just hollow shells acting as strawmen for the Fed, buying Treasuries from the US government, and MBS from Fannie and Freddie and the FHA on the Fed’s behalf. Meanwhile they play side games accumulating, marking up, and marketing all manner of other assets, particularly stocks.
But now the Fed is getting out of the buying business. No more backstopping the dealers with constant massive funding. Meanwhile, the dealers are still REQUIRED, by virtue of their status as Primary Dealers, to still buy Treasuries.
How exactly will they be able to do that without steadily being cashed out by the Fed to the tune of a hundred and some billion per month, month in and month out?
The Fed will probably tell us tomorrow that it’s going to zero purchases after March. The dealers must keep buying. There are only two ways they can fulfill that responsibility. They’ll either have to sell stuff first. Stuff, as in other Treasuries, other fixed income instruments, OR, drum roll please…… Stocks! Or they will need to borrow more money, that is, increase their leverage even more.
We’ve seen all of those processes in action in the past two weeks. We’ve also seen them report lower than expected profits. Why? Because they’re getting their asses kicked on those massively leveraged net long positions in fixed income.
And the Fed thinks that it can just withdraw from supporting the market with its massive money printing operations to buy virtually all of the debt the US government issues? Well as I told you before, oh, you can’t do that!
This little demonstration we’ve gotten over the past two weeks is just a taste of what’s to come until the market again forces the Fed to reverse course. We don’t know where or when that will be, so for now we just rely on Rules Number One and Number Two.
- Don’t fight the Fed. and,
- The trend is your friend aka, don’t fight the tape
Bounces in both the bond and stock notwithstanding, the Fed’s policy is clear, and the trend is clear.
In the last version of this Primary Dealer update in December I wrote, “At the very least, we need to be prepared for a sharp selloff in stocks, and what should turn into a resumption of the bear market in Treasuries.”
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