Fed Forces Primary Dealers To Buy Ever More Short-Dated Paper As Corporate Bond Holdings Drop To Decade Low

Tyler Durden's picture

Earlier today, Bloomberg came out with an article titled "Dealers Declining Bernanke Twist Invitation" in which the authors make the claim that "Wall Street banks are increasingly choosing to hoard their U.S. bonds rather than sell them to the Federal Reserve as speculation grows that a slowing economy and global financial turmoil will only make them more dear." As the argument, Bloomberg points out ever lower Bids To Cover in the near-daily sterilized POMOs that the Fed conducts as part of Twist, which actually is a meaningful if very volatile argument and which may be far more impacted by how much money the New York Fed is letting banks skim off the margin in daily POMOs as ZH has discussed previously.  More impotantly, BBG notes the record holdings of Treasury bonds by Primary Dealers (something we too did a month ago). It even goes on to quote 'serious people' - "People are not willing to sell Treasuries" said Thanos Bardas, a managing director in Chicago at Neuberger Berman LLC, which oversees about $89 billion in fixed-income assets, in a June 28 telephone interview. "The data in the U.S. doesn’t look as good. The labor market has lost momentum. There will be more upside left in Treasuries despite the low levels of rates." All this would be correct if it wasn't for one small detail: the distribution of UST holdings within the Dealer inventory.

As we have repeatedly shown, once one looks at just what Dealers hold, the story flips diametrically. In fact, according to the most recent Primary Dealer data released by the FBRNY (as of June 27), of the $106 billion in Dealer Treasury holdings, a whopping 78% are in the 3 Years and under category, in other words precisely what the Fed is selling to the Dealers per Twist!

That Dealers are then unable to offload this ZIRPing inventory (because as is well known all paper up until 3 Years has largely negative real rates) actually solidly refutes the story's thesis: Dealers are more than happy to play Twist, but nobody else wants to buy what the Fed sticks Dealers with. Hardly an indication of ravenous demand for US paper.

Indeed, what Bloomberg should have done is look at the proportion of paper 3 Years and above historically held by Dealers to get a gauge of just how much demand there is for Treasurys. And at 22%, this is about as good as it has been, especially when one considers the net $10.6 billion short position in 6-11 year paper which is the largest since April 25.

What is perhaps most confounding, and what completes the picture, is that as the Fed has forced Dealers to buy up more and more sub-3 year paper, PDs have been forced to find a release valve elsewhere, and sell securities to make room for all this ZIRP paper. That somewhere is corporate bonds, which as the second chart shows, is at $60.9 billion, or the lowest total since May of 2002. One can argue that the Volcker rule is making holding on to corporate paper prohibitive but since Volcker rule is nowhere close to implementation that would be disngenuous.

What the PD rotation out of corps and into TSYs certainly does do, however, is to reduce liquidity in the bond market as dealers no longer have cash (non-CDS paper) in stock, pushing bid/asks to the widest they have ever been (as Citi's Stephen Antczak recently explained phenomenally well in the June 1 paper titled Bid Wanted! Coping with Market Illiquidity).

In other words, all that Bloomberg has shown is that as the Fed's Twisting continues, its secondary effects on the market continue to deteriorate an already collapsing liquidity infrastructure, until at the end TSYs will be the only product that has any liquidity left to it, forcing everyone to become a bond trader, and shortly thereafter, vigilante.

As an apendix for those curious, here is a summary of all bond sales conducted by the Fed in 2012: total of $274 billion in short-dated paper sold. The Fed sure doesn't seem to be having a problem with any of these sales.