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Category: 1 – Liquidity Trader

Reports on the Fed and Treasury, Primary Dealers, real time Federal tax collections, foreign central banks, US banking system, European banking system, and other factors that affect market liquidity. Resulting market strategy recommendations. 7-8 reports each month. Click here to subscribe. 90 day risk free trial!

Here’s Why A Recovery Narrative Will Be Catastrophic for Markets

To the degree that it’s true, the idea that the US economy is recovering is a catastrophic notion for the financial markets.

Surprisingly, the withholding tax data supports the idea that a small number of jobs did come back in May. The problem is that the bond market reacted as if a big recovery is on the way. Investors and traders, made a mountain out of a molehill.  Bond prices plunged and yields soared. This is exactly the opposite of what the Fed and dealers wanted and needed. If it’s not reversed immediately, to say that it will be problematic would be an understatement.

Here’s what you need to know.

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Dealers Don’t Care That Fed is Tightening, But They Will on Friday

We’ve watched this bizarre scene unfold where the Fed is gradually reducing QE, the Treasury keeps pounding the market with new supply and stock prices keep rising. Here’s how they did it, and what changes ahead will force a change in the outlook.

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Dealer Dementia, Payback Delayed but Not Denied

I’ve marveled at the ability of the players to keep stock prices rising despite the reduction of Fed QE, and the continued pounding of Treasury supply on the market. Even more amazing is the fact that the rally in stocks has NOT come at the expense of the Treasury market. The Treasury market has managed not to blow up.

“How are they doing it?” I have wondered. And WTF does it mean for the future?

I have some answers, but not all. Obviously, as much as I’d like to get there for your benefit, I have never come remotely close to finding all the answers. Fortunately, I just need enough of the right ones to get the direction of the market right. Right now is a particularly difficult time for that. The Fed is barely absorbing 20% of new Treasury issuance and bond prices stay high and stock prices keep going higher?

My thinking has been that, no, you’re not wrong, Lee, the market is overstretched and vulnerable.

How can this be happening? Simple. The dealers and other big market participants are again piling on more leverage. They’re making the same mistake they always make right before everything blows up. The shock is how quickly they forget the lessons of recent history. Short term memory loss I guess. It’s dementia. That’s it. The dealers have dementia.

So here we are. Yet again, those who do not remember the past are condemned to repeat it. Here’s why, and what to do about it.

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Primary Dealers Go Hog Wild Net Long Treasuries

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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Treasury Issuance Catches Up With QE and That’s Not Good

Treasury issuance has caught up with QE. There are no more excess funds lying around for dealers to use to mark up stock and bond prices. The balance has shifted. It’s not as bullish as it was, that’s for sure. And it could get much, much worse in the weeks ahead before the Fed reacts.

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Federal Withholding Tax Collections Chart

You Have No Idea How Bad This Really Is

In normal times, the Federal Government has a revenue windfall in April, and runs a large surplus for the month. Revenues are typically at least 140% of outlays. Even more in good years.

Revenues covered just 24% of outlays in April. We borrowed 76 cents of every dollar the Federal Government spent last month.

We knew this was coming. The questions now are how long it can last, when it will start to recover, and whether it might get worse.

The monthly Treasury Statement data illustrates the depth of the budgetary crisis that have engulfed the financial markets. It showed that the Federal Government had to finance a deficit of $742 billion for the month. But that apparently doesn’t include a little cash flow matter of $230 billion the government paid out in tax refunds in April. That’s a gargantuan number that we saw in the Daily Treasury Statement data that I reported last week. Therefore on a cash basis, the deficit was more than a trillion. That had to be financed through debt offerings.

The Daily Treasury Statement data through May 12 shows that the situation is not only not getting better. It hasn’t stopped getting worse. The worst readings on withholding tax collections just happened Friday and Monday. Here’s how it looks now, and guidance on how we’ll know when it’s beginning to recover.

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Fed’s Curve Flattening Starts To Flatten Stock Prices

The Fed has cut back its POMO purchases to an average of $8 billion per day of Treasuries and $6 billion of MBS this week. That’s down from $10 billion and $8 billion last week, and hundreds of billions in the peak of the panic in April.

The effects of that are beginning to show up in stock prices.  Be prepared because here’s what happens next.

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