Author: Lee Adler

NOTE! This report has been updated here with important previously overlooked information. 

Withholding taxes plunged in December. They are by far the largest component of Federal tax revenue. This was not an anomaly. It was a continuation of a downtrend that began in November. This trend is a sign of economic weakness, recession, and most importantly, the fact of less revenue than expected. The US Government schedules Treasury issuance on the basis of revenue forecasts. When revenue falls short of the assumption underlying the supply forecast, it means that Treasury supply will increase. Now this will come from an already heavy forecast level in the first quarter. Non-subscribers, click here for access.

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Despite market expectations of lower interest rates ahead, the Fed is not yet refilling the punchbowl. The existing punchbowl, the Fed’s RRP facility, continues to be drained. It will run out of funds xxxxxxxxz xxxxxx xxxxxxxx xxxxx xxxxxx. Only the timing is at issue. The fall in tax revenues suggests that the day of reckoning will come sooner rather than later. I’m back to projecting xxxxxxxxx xxxxxxxxxx xxxxxxx, but we’ll adjust that expectation as we determine day by day xxxxxxxxx xxxxxxx xxxxxxxx xxxxxxxx, and whether RRP slush fund withdrawals are xxxxxx xxxxxxxx xxxxxx xxxxxxxxx.  Non-subscribers, click here for access.

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Tracking total Primary Dealer financing, as reported weekly by the New York Fed, shows us the approximate level of risk inherent in dealer positions. This analysis includes not only their outright positions, repo financing, but also net Treasuries borrowed, which is a proxy for short positions that hedge outright positions held. We then include dealer fixed income futures hedges. This combined view tells us whether they are long or short on balance. It also gives us a view of how leveraged they are. Non-subscribers, click here for access.

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The dealers have gone whole hog in terms of repo borrowing and maximum leverage since September. They first got there in mid-July. That was reversed by a period of deleveraging that lasted into September, accompanied by weaker markets. But then they came roaring back, pedal to the metal, with maximum leverage. Non-subscribers, click here for access.

At the same time, money has poured out of the Fed’s RRP slush fund at a breakneck pace as investor psychology turned more and more bullish. The Fed even followed the crowd this week, suddenly pivoting its guidance toward rate cuts next year, surprising the markets. Non-subscribers, click here for access.

$900 billion in cash has come out of the Fed’s RRP facility since September. Market participants have used that cash to buy not only T-bills, but also stocks and bonds. Combine that with the increased use of leverage by the dealers over that same period, and a temporary reduction in Treasury supply in December, and the stock and bond markets have been on fire. Non-subscribers, click here for access.

This too shall pass, but the question is when. The Primary Dealer positioning data alone doesn’t tell us that, but it does give us an idea of the elevated level of risk. It suggests that when Treasury supply returns to normal, and the RRP slush fund runs dry, the markets could be in for a sudden and violent turn. Non-subscribers, click here for access.

I initially estimated in prior reports that the RRP facility was heading toward zero in xxxxx, but as the pace of withdrawals has accelerated in the past few weeks, we adjusted that to xxxxx. The current data through Friday suggests that that’s still the target. But before that, Treasury supply will mushroom again xxxx xxxx , and will be heavy in xxxxxx. The ruts in the road should start to show up then. Non-subscribers, click here for access.

With the Fed’s pivot in rhetoric this week, the euphoria has been thick. Light T-bill supply until xxxxxxx xxxxxxx xxxxxx should keep that going. Meanwhile investors and dealers have continued pulling money out of the Fed’s RRP facility at a breakneck pace over the past couple of weeks with no T-bill supply driving that. That means that instead of simply buying T-bills as they usually do with that cash, with the T-bills then being used as collateral for more repo borrowing, dealers and investors have gone to directly buying stocks and bonds. Non-subscribers, click here for access.

I see no reason for that to change over the next xx xxxxx. But a big Treasury coupon settlement in xxxx xxxxxx xxxxxxx should present a roadblock, with more supply in xxxxxx xxxxxxx xxxxxx xxxxxxx giving an overleveraged dealer market a reality check. Non-subscribers, click here for access.
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When the 10-year yield hit 5%, we recognized that it was time for a bond rally. It has come with a vengeance. Now it is time to start looking for signs of a bearish turn there as we head into xxxxxxxx xxxxxxx xxxxxxx. Stocks should follow suit as investors wake up to the fact that the cash that fueled the buying frenzy will soon run out. Non-subscribers, click here for access.

Bottom line, I would not be xxxxxxx xxxxx xxxxxx xxxxxx but xxxxx xxxxxxx xxxxxx xxxxx. Non-subscribers, click here for access.

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