The Primary Dealer System is Deadly

Below is the entire text of an article I found on Zero Hedge. Here is a link to the post on ZH. I want to capture this article for future reference because it does a good job of describing the Primary Dealer system which is a giant financial squid that has its grip on the throat of the governments around the world and has supported financial corruption in the developed economies in the world. No editorial changes, it is copied as published at ZH.

"Yesterday I noted that the “addict/ dealer” metaphor for the Fed’s intervention in the markets was in fact not accurate and that the Fed’s actions would be more appropriately described as permitted cancerous beliefs to spread throughout the financial system, thereby killing Democratic Capitalism which is the basis of the capital markets.

Today I’m going to explain what the “final outcome” for this process will be. The short version is what happens to a cancer patient who allows the disease to spread unchecked (death).

In the case of the Fed’s actions we will see a similar “death” of Democratic Capitalism and the subsequent death of the capital markets. I am, of course, talking in metaphors here: the world will not end, and commerce and business will continue, but the form of capital markets and Capitalism we are experiencing today will cease to exist as the Fed’s policies result in the market and economy eventually collapsing in such a fashion that what follows will bear little resemblance to that which we are experiencing now.

The focus of this “death” will not be stocks, but bonds, particularly sovereign bonds: the asset class against which all monetary policy and investment theory has been based for the last 80+ years.

Indeed, basic financial theory has proposed that sovereign bonds are essentially the only true “risk-free” investment in the world. While history shows this theory to be false (sovereign defaults have occurred throughout the 20^th century) this has been the basic tenant for all investment models and indeed the financial system at large going back for 80 some odd years.

The reason for this is that the Treasury (US sovereign bond) market is the basis of the entire monetary system in the US and the Global financial system in general. Indeed, US Treasuries are the senior most assets on the Primary Dealers’ (world’s largest banks) balance sheets. To understand why this is as well as why the Fed’s policies will ultimately destroy this system, you first need to understand the Primary Dealer system that is the basis for the US banking system at large.

If you’re unfamiliar with the Primary Dealers, these are the 18 banks at the top of the US private banking system. They’re in charge of handling US Treasury Debt auctions and as such they have unprecedented access to US debt both in terms of pricing and monetary control.

The Primary Dealers are:

1. Bank of America
2. Barclays Capital Inc.
3. BNP Paribas Securities Corp.
4. Cantor Fitzgerald & Co.
5. Citigroup Global Markets Inc.
6. Credit Suisse Securities (USA) LLC
7. Daiwa Securities America Inc.
8. Deutsche Bank Securities Inc.
9. Goldman, Sachs & Co.
10. HSBC Securities (USA) Inc.
11. J. P. Morgan Securities Inc.
12. Jefferies & Company Inc.
13. Mizuho Securities USA Inc.
14. Morgan Stanley & Co. Incorporated
15. Nomura Securities International Inc.
16. RBC Capital Markets
17. RBS Securities Inc.
18. UBS Securities LLC.

Economic Condition Review: August 2011

Looking back since my last review in June the world has recovered from the tsunami and earthquake damage in northern Japan (Japan is still in recovery/clean up mode), the civil revolt and dictator overthrow in Egypt has resulted in a power vacuum which will be resolved by election later, the dictator of Libya, Muammar Gadhafi, has been defeated by his opposition according to news reports. Other uprisings are beginning to build in several other oil producing countries in the region, including Syria and Persian Gulf states. The threat of crude oil shipments being interrupted is a growing concern for all countries importing from this region. Despite these pressures, the price of Brent Oil has softened recently from more the $120 to now $108.62.

In Europe, the socialist government of Portugal has collapsed and is now moving on with a new center-right government. The government of Greece has had to renegotiate the bailout terms with the ECB (Germany and France) as a condition of getting the last installment of their bailout package. The renegotiated plan now calls for Greece to liquidate much of its net worth (state owned assets like airports and transportation services) as well as agree to new austerity. Can it get any more dire in Greece? Misery likes company and Italy, the eighth largest economy in the world, is drawing attention to itself for having public debt at 120% of GDP. That's second, to Greece, in the euro zone. Spain is on the radar screen now as well.

China is still wrestling with internal high food and shelter inflation threatening the massive lower classes, potentially destabilizing the power of the ruling party. Published reports describe interest rate increases are the tool to fight inflation in China, to slow lending for business and personal discretionary consumption.

In the US, the Treasury market is finding some strength on a risk-off move. The yield on the 90 day Bill is 0.00%, the 2 yr T-note is 0.19% and the 10 yr T-bond is 2.06%! The US$ is weak, trending between 73.50 and 76.00 during the past several months, and currently near the 74 mark. 'Risk off' has been a reaction to the US Congress displaying their lack of ability, building the case daily until the beginning of August when they finally extended the US public debt limit. The public display of incompetency was so much greater than expected that some economic activity slowed as a result of the spectacle and resulting loss of confidence in the leadership ability of the US government.

Calculated Risk has a summary of the recent economic reports which illustrate that the economy is not growing, but is not collapsing into recession. New home building is slow and existing home inventory is still large. Industrial production is  trending sideways or improving. Same trend for production capacity utilization.

The Federal Reserve is pulling the strings to guide global perception about the strength of the US$. The Fed has no choice but to continue it's zero interest rate policy and money printing practice. They will attempt to support the Treasury market when the primary dealers and global participants back away more than they have now. As mentioned above, yields are at historic lows. Doug Noland has this caution in his blog this weekend. "Fiscal and monetary policies are rapidly losing credibility.  Treasury prices may be inflated, but don’t mistake this for confidence in our system’s “core”." Financial markets around the world are expecting a return to quantitative easing (QE3) sometime soon. Bernanke is speaking at the annual Fed Conference at Jackson Hole where last year he hinted at QE2. The world will wait for his message on Aug. 26. Calculated Risk has a post on what he expects from this years Jackson Hole speech. There is a building awareness that the Fed is wrecking the currency. On top of the loss in confidence for the US government, the reaction to a new plan of quantitative easing does not guarantee support for financial markets. Doug Noland writes "The American people no longer buy the notion that piling on more debt and “money printing” offers a reasonable solution.  They are appreciating that it’s instead the problem, and there will be less tolerance for this “experiment” going forward."

US Treasury Debt Demand Weakens

This week saw several auctions of public debt issuance. The results are a possible signal that there is less demand for US debt than in the past. Here are results for the 2 year note, 5 year note and 7 year note. Highlights are written by Econoday.
On the 2 Year Note auction:
Highlights
This week's run of coupon auctions is getting off to a slow start. Coverage of 3.08 for today's $35 billion 2-year auction is on the low side of trend and is well below May's 3.46. The stop-out rate of 0.395 percent is one basis point higher than the one o'clock bid. In another sign of weakness, dealers were awarded 65 percent of the auction which is the most in more than two years. Demand for Treasuries is easing following the results. Tomorrow the Treasury auctions $35 billion of 5-year notes.
On the 5 Year Note auction:
Highlights
Buyer resistance may be appearing for Treasuries, judging by yesterday's soft 2-year note auction and today's even softer 5-year auction. Coverage is 2.59, the lowest of the last ten auctions, all $35 billion in size. In another sign of weakness, the high yield of 1.615 percent is more than two basis points above the one o'clock bid. Dealers ended up taking down 52 percent of the offering for the highest rate of the last four auctions in yet another sign that demand is soft. Demand for Treasuries is falling in reaction to the results which point to trouble for tomorrow's $29 billion 7-year auction.
On the 7 Year Note auction:
Highlights
Treasury supply may finally be getting ahead of demand. That's a conclusion that can reasonably be drawn from this week's poorly received string of coupon auctions including today's $29 billion offering of 7-year notes. Coverage of 2.62 is light for this issue while the high yield of 2.43 percent is three basis points over expectations. In a sign of weak retail demand, dealers ended up taking down an outsized 56 percent share of the offering. Demand for Treasuries is sinking following today's results.

Here is a look at the IEI daily graph (iShares Barclays 3-7 Yr Treasury Bond index):

10 Yr Treasury Shows Nominal GDP is Under 3%

Dr Ed Yardeni comments on the dynamics of bond market pricing in his post titled "The Bond Yield". He makes the point that bond yields and the expected nominal GDP rate have a lot in common. Yields tend to revert to the expected nominal GDP rate.

GDP is a measure of the output of goods and services produced by labor and property located in the United States. It is also an indicator of broad US based economic activity that is expected to be reflected in the stock market.

The article focuses on 'expected' rather than 'stated' GDP rate. According to John Williams at Shadow Government Stats, "GDP reporting remains the least meaningful and most heavily gimmicked/politicized of the major economic series, at least in the first year or so of reporting."

Expectations for GDP are useful to provide hints about the near term trend of consumer confidence and stock market sentiment. It is fuel for the bulls and the bears, depending on their bond yield expectation.

Ten Year Note auction 3/2011

Todays auction was completed in strong action. Econoday reports "All readings on today's 10-year Treasury auction are strong. Coverage of 3.32 compares with a long-term average of 2.50 while the stop-out rate of 3.499 percent is nearly three basis points below the one o'clock bid. Buyside participation was strong, indicated by a smaller-than-average dealer takedown of 41 percent."

At the same time, Pimco's Total Return Fund is reported  by Reuters to have sold all its U.S. government-related securities, including U.S. Treasuries and agency debt. The article goes on that Bill Gross is saying there is going to be a loss of bids for treasuries, raising yields, if the Fed ends QE2 at the end of June. The posturing here is clear. Bill Gross is voting for more QE2.

Ten Year Note: Looks Good??

Bloomberg reports on today's auction of the ten year note. "In complete contrast to yesterday's 3-year auction, buyside demand was very strong for today's 10-year auction. Dealers ended up with only 28 percent of the $24 billion offering, well under January's 39 percent. The auction stopped out at 3.665 percent, five basis points below the 1:00 p.m. ET bid. Coverage of 3.23 is up from January's 2.80. Demand for Treasuries is rising following the results."

Peter Boockvar also reported on the auction at the Big Picture blog. "The benchmark 10 yr note auction was very strong as the yield of 3.665% was well below the when issued of 3.70-3.71% and the bid to cover of 3.23 was above the 12 month average of 3.12. Also, indirect bidders took 71.3% of the auction, by far the most since at least 2003 which I can’t explain and thus the dealers took only a modest amount. The Treasury definitely got some help today and it’s likely that the highest yields since May became attractive to buyers and the spread to the 2 yr at near record highs became stretched. The Treasury sells 30 yr paper tomorrow and will also be important."

Ten Year Note: Somebody's Buying

 This info is reported by Econoday on Bloomberg:

Bid/Cover	3.30
Coupon Rate	2.625%
Total Amount	$21 B
Yield Awarded	3.388%

Highlights
New Year investment inflows are flowing into Treasury auctions this week especially today's 10-year auction (a reopening of the 2.625 percent November issue). Retail demand appears to be especially strong as dealers ended up taking only 39 percent of the auction vs a 46 percent average. (Scanner: emphasis added) Coverage of 3.30 is well above average. Topping it off, the auction stopped out at 3.388 percent, two basis points below the 1:00 bid. Money is moving into the Treasury market following the results.

Scanner: The chart below shows that the Total Amount for 2009 is identical to the amount of the auction in January 2011. The amount with the annual reports is the average for monthly auctions in the year. The 2010 monthly reports are showing the monthly auction amounts.

Ten Year Demand is Weaker, Yields Rising

From Bloomberg/Econoday: Results for the $21 billion 10-year note auction (a reopening of the 2.625 percent November issue) are no better than average. Coverage of 2.92 is up slightly from the prior auction yet is still the second lowest since the February auction. Buyside participation is right at averages with the group taking down 56 percent of the auction. At 3.340 percent, the auction stopped out right at the 1:00 p.m. ET deadline. Tomorrow the Treasury auctions $13 billion of 30-year bonds. Treasury prices moved slightly higher following the results.

Fundamentally Speaking, Now is a Confusing Time

Quantitative easing (QE 2) has begun and the markets are pretty confused, based on volatility of commodity prices and daily currency exchange swings, and the VIX. It's a terrible time to try forecasting a market's direction amidst all the financial situations around the world (Ireland banks, China inflation, Yen direction, euro direction, US$ direction) as well as the economic influence of QE 2 operations. There is also speculation about the process the Fed has chosen for it's QE 2 plan and whether it will be successful soon, if ever. An interesting observation of the plan is described in "They Just Don't Get It", written by Paul Kasriel.

Kasriel observes that the Fed is targeting the middle-term sections of the maturity spectrum, avoiding the bill's, or short-term issues. He contends that the Fed may have to deliver more easing until they can move the needle of credit outstanding up. He writes "The Federal Reserve has the unique ability to be able to create credit figuratively "out of thin air." So does the commercial banking system, if the Fed provides the "seed money." The ability to create credit out of thin air implies that the recipients of that credit can increase their current spending without any other entity in the economy having to cut back on its current spending. 

10 Year Treasury is Still in Demand

Good news continues for the US Treasury, and the broader bond market, following today's ten year note auction. This information is found on Bloomberg today following the auction:

Highlights
Buyside interest in the monthly 10-year auction was strong. Direct and indirect bidders took down a combined 62 percent of the auction, nearly 10 percentage points above average. At 3.21, coverage for the $21 billion reopening of the August issue was the strongest since June. The auction stopped out at 2.670 percent, nearly two basis points below the 1:00 ET bid. Money is moving into Treasuries following the results. Tomorrow the Treasury auctions $30 billion in 30-year bonds.

10 Year Treasury is Still in Demand

Good news continues for the US Treasury, and the broader bond market, following today's ten year note auction. The 3.50% coupon is getting a premium in the auction, helping the fiscal crisis in the US. This information is found on Bloomberg today following the auction:

Highlights

Coverage for the $21 billion reopening of the 10-year June issue is on the low side at 3.09. The auction, stopping out at 3.119 percent, shows a 1-1/2 basis point tail. Buyside demand is no more than moderate with direct and indirect bidders taking down 52 percent of the auction, in line with the long term trend but down from the recent trend. Demand for Treasuries is easing following the results.

Ten Year Bond Still in Demand

Good news continues for the US Treasury, and the broader bond market, following today's ten year note auction. This information is found on Bloomberg today following the auction:

Highlights
Results are solid for the Treasury's monthly 10-year note auction, which this month is a reopening of the May issue. The $21 billion auction stopped out right at the 1:00 bid, at 3.242 percent with coverage at a better-than-average 3.24. Non-dealers took down 54 percent of the auction, no better than average. Slightly smaller auction sizes helped results for both this auction and yesterday's 3-year auction. Auction size for tomorrow's 30-year auction is also on the low side, at $13 billion.

10 Yr Treasury Note is Still in Demand

Here is a summary from Bloomberg following today's ten year note auction. For some longer historical perspective, see an earlier post about the 10 yr Note. Briefly, yield has fallen from 3.90% in the April auction when the bid-to-cover ratio was a nine year record high 3.72. This month shows a ratio of 2.96 indicating less enthusiasm for the Note, but still historically strong.

Bidding was aggressive for the month's 10-year note auction, an oversize $24 billion offering where coverage came in at a solid 2.96. Dealers are definitely losing business as direct bidding was very aggressive at 25 percent. Indirect bidding was also firm, at 42 percent, making for a combined 67 percent non-dealer takedown and far above the 52 percent average.

High yield of 3.548 percent was right at the 1:00 bid. A look back at the high yield in last month's auction offers a key yardstick for the sovereign-risk effect. The April yield was more than 35 basis points higher than now, this during a time when U.S. economic data have strengthened! Tomorrow the Treasury auctions $16 billion of 30-year bonds.

10 Yr US Treasury is in Demand

Here is the detail from the Treasury, including some explanation of terms, following today's ten year note auction. Also, this information is found on Bloomberg today following the auction:

Buyers have returned in force to Treasury coupon auctions. The April 10-year note auction, a reopening of the February 3.625 percent coupon, posted a bid-to-cover ratio of 3.72 for the highest ratio in the last nine years of data.

The $21 billion auction stopped out at 3.900 percent, 3-1/2 basis points below the 1:00 bid. Retail demand was very strong with direct and indirect bidders taking down 59 percent of the auction vs. an average of 51 percent.

The chart below shows that the Total Amount for 2009 is identical to the amount of the auction in January 2010. The amount with the annual reports is the average for monthly auctions in the year. The monthly reports are showing the monthly auction amounts.

 

US Treasury 5 Yr Auction Results, 2010-02

Peter Bookvar posts the follwing description of todays Treasury Bond auction. This periodic auction is important because it the earliest sign of a game change in the global economy. As long as there are buyers for the debt, the Keynseian game is still in play. When it is game over, we better have our plans set for action. There are only guesses about when that will occur, from months to years. It's not even certain that it will, though it does appear to be good bet by most observations.

The 5 year note auction was mixed as the yield was slightly above the when issued but the bid to cover at 2.75 is the 3rd highest dating back to Sept ‘07 and is above the average over the past year of 2.38. Indirect bidders took 40.3% of the auction which is the lowest since July but direct bidders bought 12.8% of it which is on the very high side. The dealer community is thus being put a bit more in the dark over what the true demand is and where its coming from. Today’s auction follows an excellent 2 yr note auction yesterday and the maturity of 5 years falls somewhat in no man’s land this week ahead of tomorrow’s 7 year auction and this past Monday’s 30 yr TIPS auction. Therefore, not much can be gleaned today in terms of what the bond market sentiment is with respect to growth, inflation and risk appetite.

The Case for Deflation Described and Challenged

Curious George has offered another post for me to assemble. It is so interesting that I want to frame it as a debate between the primary author, Gary Schilling, and the debater, Curious George. Gary Schilling has posted a very good description of deflation that you can link to. The title of his post is 2010 Investment Strategies: Six Areas To Buy, 11 Areas To Sell. For anyone who wants to see what a deflationist outlook is, this is the spot. Curious George introduces Schilling and then challenges his beliefs. I'll use colors to distinguish the two, Schilling's beliefs in orange, Curious George's challenges in green.

Gary Shilling is a long-time Forbes prominent investment advisor and economist. He is mostly a stock market bear and deflationist. While there is much to agree with in his 2010 forecast, there is plenty to debate. Shilling is far more experienced and credentialed than I but he is not beyond questioning.

We see the 2010 investment climate dominated by weak economic growth here and abroad, led by U.S. consumer retrenchment. More government fiscal stimulus and continuing Fed policy ease are likely in this setting. So is low inflation or deflation.

Don't trash our US Treasury reserve holdings, or else...

Another gem found on Safe Haven is written by Clive Maund, a gold bug. His article is making several observations that are important to be alert to. He is in a small number of market watchers calling for a much higher dollar. Most interesting, is the discussion that the stock market is subordinate to the Treasury market and is therefore a sacrificial lamb anytime protection of the dollar is needed. Finally, his article includes an interesting technical analysis of gold and it lends support to his other points, such as a strong dollar. This is certainly effective at helping me better appreciate the job in front of Bernanke.

Big overseas Treasury holders such China and Japan are believed to have "strong-armed" the US in the recent past behind the scenes and essentially said "You either quit undermining your currency and defrauding us with your zero interest rate policy or we are going to dump them, big time, and collapse the Treasury market." The Treasury market is the "aorta" of the US, which involves swapping essentially worthless paper for the goods and services of countries that are dumb enough to buy them, thus allowing the US to live way beyond its means running continuous massive deficits. It is viewed by the administration as infinitely more important than the stockmarket, which is small in comparison. It is thus clear that if it is necessary to sacrifice the stockmarket by raising interest rates to rescue the Treasury market, then that is what's going to happen.