Lee AdlerThe balance between QE and Treasury supply will begin to shift in July. The underlying bid it has provided for stocks and Treasuries will begin to fade.
This report tells why, and what to look for in the data and the markets.
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)
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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FREE REPORT – Proof of How QE Works – Fed to Primary Dealers, to Markets, To Money
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.
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).
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FREE REPORT – Proof of How QE Works – Fed to Primary Dealers, to Markets, To Money
Stock prices are currently right in the middle of the channel surrounding the liquidity line in the Compositite Liquidity Chart (viewable in subscriber version). By this measure the market isn’t overbought, as so many bearish pundits are bellowing. Nor is it oversold. It’s just tracking the growth of systemic liquidity. Not too hot, not too cold, but just right. Goldilocks.
The balance between QE and Treasury supply will remain bullish through through xxxx (subscribers only). This should provide a boost for stocks. It should keep the Treasury selloff at bay for another month or two.
However, this is not as bullish as I first thought. It appears that around 75% of the T-bill paydowns are going to money market funds and other institutions who must hold short term instruments instead of lengthening maturities or buying stocks. So most of the cash from the paydowns is ending up in Fed RRPs.
Only about ¼ of the money has been used to buy stocks and bonds. So the effect has been muted. There’s no massive blowoff. Instead conditions lend themselves to a churning topping action lasting through xxxx (subscribers).
Every time there’s a critical problem in the banking system due to banker malfeasance, the Fed steps in to paper it over and reward the criminals.
That’s why we focus on the Fed more than anything else. Regular review of the banking indicators was useful once upon a time. The Fed has rendered them irrelevant. But I promised to keep an eye on them, and it has been 5 months since we last looked. That’s enough time that, if anything material has changed, we need to know about it. So herein is a review, our first since last December.
In this report, I highlight the charts. Because there are so many, I’ve attempted to minimize the verbiage. I talk too much. The charts really speak for themselves.
The bottom line is that the system remains extremely vulnerable to a decline in Treasury prices that is coming in xxx (subscribers only). Likewise, the return of optimism in commercial real estate is problematic. The banks are taking no precautions. There’s no sign of recognition of the looming losses.
It means that the entire banking system could be destabilized in xxxxx (subscribers only). The Fed will have to act, massively. History shows that the Fed won’t act in time to prevent a breach of the system. History also shows that the Fed has the power to ultimately make its actions give the appearance of stabilization, leading to the return of animal spirits.
But I don’t know if it will work yet again, and we can at least expect a significant break first. So here’s what I would do (subscribers only).
Now here’s a review of the banking indicator charts.
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FREE REPORT – Proof of How QE Works – Fed to Primary Dealers, to Markets, To Money
The balance between QE and Treasury supply has gotten even more bullish and will remain so until xxxx (subscribers only). This should provide a boost for stocks. It should keep the Treasury selloff at bay until xxxx (subscribers only).
I have previously made the case for the Treasury to run out of money in xxxx (subscribers). If that estimate is correct, the outlook will turn negative in xxxx (subscribers). But for now, bullish liquidity forces remain in place, outside of the usual month end supply pressure.
As delayed tax receipts come in, in May, the Treasury will have even more cash for paydowns. The rest of May into mid June could be very bullish as a result. A selling opportunity for both stocks and bonds will arise as the Treasury approaches the point where its cash hoard is used up.
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FREE REPORT – Proof of How QE Works – Fed to Primary Dealers, to Markets, To Money
The Treasury Borrowing Advisory Committee (TBAC) is a gang of Primary Dealers and other big investment firms that tells the US Treasury once each quarter how much paper it will need to issue, and when. It provides an estimate of issuance by date and type for the current quarter and the next one. It does so every February, May, August, and November, near the beginning of the month.
The TBAC just issued its reports for the current quarter last week. The report confirms what we expect, a massive supply increase coming. We know exactly when it’s coming, and have a pretty good idea of when it should start to cause problems for the stock and bond markets. With that knowledge, we can now prepare for action to take advantage.
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The markets are awash in cash. It shows up on the Fed’s balance sheet. It shows up in the Treasury account, and in Primary Dealer Accounts. It shows up in Reverse Repos.
That cash is coming from the US Treasury’s campaign of paying down T-bills. Those paydowns have totaled $430 billion since February 23. It’s an abomination of market manipulation. But it has worked to stabilize the bond market, levitate stock prices some more, and some more, and some more, and to stave off yet another Primary Dealer collapse.
We can follow these flows via the Fed’s weekly balance sheet statements, and the charts and indicators we derive from it.
The Treasury still has $1 trillion in its account that it must spend down. Annual taxes are still coming in, replenishing that account. The Treasury will almost certainly continue to pay down T-bills until there’s no cash left. I will do a revised estimate of when that will be from the April end of month Daily Treasury Statement. Prior to that, I give my best current swag in this report.
Until then, the cash will continue to flow. This report shows you exactly how this impacts stocks and bonds, so that you know how to play it, and when to GTFO.
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The balance between QE and Treasury supply remains bullish. This should provide an underpinning preventing the stock market selloff from going too far. At the same time, Treasuries have apparently put in an intermediate term low.
May will be even more bullish, but there are trends in place that will end the party, and we have a pretty good idea of when.
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