These Two Market Insider Indicators Have Warned of Treasury Market Collapse For Months
by Lee Adler, Wall Street Examiner
Two indicators that I track weekly in the Professional Edition Fed and Treasury updates warned last year that things could turn ugly in the bond market. One follows the Primary Dealers’ Treasury holdings and the other follows the Treasury holdings of all commercial banks operating in the US.
Contrary to popular belief, the Primary Dealers aren’t exactly the smart money. In fact, if you look at the record, they look like the dumb money, little more than trend followers who get suckered like everyone else. They are, after all, the ones who caused the financial crisis. Among their number are the very same banks that drove the credit bubble that led to the crash, the ones whom the Fed and US taxpayers were forced to rescue. So let’s start by recognizing that they ain’t so smart. Greedy, yes. Powerful, absolutely. But smart? Not so much.
The record of their portfolio holdings of fixed income securities shows them to be trend followers. They have been heaviest short at market bottoms (highs in yields) when they should have been most heavily long. Likewise, they’ve been most heavily long at bond market tops (lows in yields) when they should have been short.
They had built a huge short position in Treasuries in May 2011 just as the bond market was embarking on a huge 13 month rally that led to the all time lows in June 2012. The dealers followed the market, going from net short to net long in August 2011, and continuing to build their long position as the bond market rallied. Their buying was one of the drivers of the rally. Their long positions peaked at an all time record in June 2012. They nearly equaled that record in September 2013. In other words, they held never before seen record long positions concurrent with the very top of the market and the record lows in yields. Talk about being positioned wrong. I wrote at the time that, given their record of being most wrong at major turning points, that the double top in their Treasury longs was likely the end of the line for the bond bull market. Sure enough, that has been the low water mark in yields so far.
After the second peak in their positions the dealers sold aggressively in January and February of this year. Then they bought like mad for a month but in April started selling again. The pattern of a lower low and lower high is a classic distribution pattern in technical analysis. It is a sign of a bear market. The same pattern is now clearly evident in the inverted yield graph. It’s been under way for a year. That, in my book, is a bear market. The dealers remain heavily long however, and that means they’ve been taking some pain in their portfolios. This can become a negative spiral feeding on itself.
Ironically, the Fed has been cashing them out to the tune of about $110-115 billion per month, including the new Fed’s MBS purchases plus the Fed’s purchases to replace the MBS being paid down from its balance sheet, plus the daily purchases of Treasuries. This may be forcing the dealers to be buyers in the market when they don’t want to be. As yields have turned up, they’ve been forced to take losses and to reinvest the cash which the Fed has been stuffing down their throats, leading to more losses. It’s counter intuitive and it wasn’t supposed to work that way, but that’s what has been happening lately. The dealers have funneled some of the excess cash into stocks, and that worked until last week. But as Japan has shown lately, even that trade may not work at some point.
US commercial banks in general haven’t been big buyers of bonds since November 2010. But there was a period which was an exception. Here again, the banks were buyers on balance from March 2012 to December 2012, the worst possible time, when bond prices were highest and yields were at their lowest. Their buying peaked on June of 2012, at the exact top of the bond market in price and low in yields. What could be dumber? They immediately began reducing their purchases and have been sellers on balance in all but a few weeks this year.
At their extremes the dealers and banks are a fade. They topped out the market with a massive wave of purchases as the bond buying panic reached a crescendo last year. The losses they are taking on those positions have led to distribution, which has contributed to the rise in yields. If past history is any guide, the yearlong bear market in bonds isn’t likely to end until the dealers and banks start buying again.
Banks have become heavy sellers of Treasuries and that could lead to an intermediate bottom in prices within weeks. But it will take more weeks for constructive patterns to appear on this chart, and it may be even longer for the Primary Dealers. They still have way too much long side exposure in their Treasury portfolio, where historically they have typically been short.
Both indicators are most useful when the reach historical extremes, then reverse. Both have tended to follow, rather than lead the market. Since neither has reached an extreme on the downside, and Primary Dealer holdings haven’t even returned to trend, it seems likely that the current trend toward higher Treasury yields will continue for a while.
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