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The House (Securities’ Dealers) Always Has the Edge

Las Vegas was not built on winners, and yet nearly 40 million people visit the city each year. Even though the casinos clearly display the odds, gamblers still gamble on the off chance they might leave a winner. The financial services industry was not built on winners either, like those at the top, who have access to a huge amount of information, leverage the market for their own profits. Even after two nasty recessions, investors believe this time they will come out ahead.

While investors have varying opinions about how high stock prices will go, there seems to be a universal belief that interest rates will have to rise significantly before investors are willing to trade their stocks in for bonds. It is this belief regarding higher interest rates that have led investors to short the bond market, or bet that interest rates are headed higher, based on numerous inaccurate assumptions.

These inaccurate assumptions have become believable since few people understand monetary policy. Arguably the Federal Reserve, who is in charge of setting monetary policy in our country, does not understand it as well as they should either.

The Fed was forced to bail out the banks during the Great Financial Crisis (GFC) because without the banks, our entire financial system would fail. The cost to bail out the banks was a staggeringly large number, but the Fed does not believe it is their responsibility to pay the entire bill. The Fed bailed out the economy with the intention of sticking global investors with a chunk of the cost. When the Fed announced they were selling off part of their balance sheet, investors were put on notice that it was time to pay.

Investors were too excited about stocks, which they believe will never stop rising in value, to concern themselves with the Fed’s balance sheet unwind. After all, Americans have relied on foreign investors to buy our debt since we went off the gold standard. Why would this time be any different?

When the Fed bailed out the banks after the GFC, they anticipated that investors would not like having bonds forced upon them, so the Fed created a relief valve. The Fed unwinds their massive bond portfolio by choosing not to reinvest the proceeds from some of their maturing bonds each month. This forces the U.S. Treasury to issue more debt to pay off the Fed’s maturing bonds and since all U.S. Treasury debt must be purchased, all of this debt is bought by investors from all around the world.

On any given week the U.S. Treasury is issuing debt. When our country’s debt goes to auction, any amount that is not purchased by domestic or foreign bidders is automatically bought by the securities dealers, regardless if they want it or not. It appears the securities dealers do not want this debt, as their inventory of bonds is increasing faster than they can sell it.

When the Fed allows their bonds to mature, they destroy the principal value they receive from the U.S. Treasury, which reduces the Monetary Base, or the total amount of currency in circulation and held in excess bank reserves. Investors believe this act of currency destruction is inflationary when by definition, the destruction of a currency is disinflationary or deflationary.

The Fed’s plan to destroy currency is working, as the growth rate of the money supply is running well below its long-term average. For currency-printing to be inflationary, the growth rate of the money supply needs to be well above its long-term average for a long period of time. Since the growth rate of the money supply is below average and the Fed is destroying currency, it is not possible to experience high rates of inflation.

Investors also believe the deluge of U.S. Treasury debt hitting the global financial markets must cause interest rates to rise, even though interest rates have steadily fallen over the past several decades, as the amount of government debt has steadily increased. Just like investors are wrong about the Fed’s balance sheet unwind causing inflation, they are wrong about large fiscal deficits causing inflation.

Securities dealers have been taking up the slack by forcibly buying any remaining U.S. Treasury bonds that are not sold to domestic and foreign bidders. Investors believe that the securities dealers will be forced to mark down their U.S. Treasury bond holdings in order to sell them. It is helpful to understand that many securities dealers, or investment banks, are owned by large banks. Since many banks are part of the Federal Reserve system, they have a deep understanding of how the Fed’s policies work.

It is worth noting that neither the securities dealers nor the Fed have complained about this arrangement. The dealers continue to buy government bonds and continue to watch their inventory of government bonds rise. While the dealers lose money on these bonds when interest rates rise, it is important to understand how the house always wins.

If the Fed was engaged, or planning to engage in, currency-printing operations that would lead to inflation, then the banks would be the first to know. In turn, the securities dealers would quickly sell any government debt they receive to avoid taking losses. The opposite is happening, as the amount of government debt held by securities dealers is rising on a monthly basis.

Securities’ dealers are where investors go to buy and sell stocks – think of a dealer as a retailer for securities. Investors are watching dealer inventories of government debt rise, so they believe the dealers will eventually be forced to sell this at a discount, which would cause interest rates to rise, or that the Fed will be forced to bail the dealers out by restarting Quantitative Easing. Neither is true.

It is the Fed who is forcing the dealers to take any unsold bonds, as this rule was created as part of the bank bailout of the GFC. If the Fed believed this was going to cause a problem and force the Fed to repurchase the bonds later, then they would not have bothered to create the relief valve in the first place. After all, the Fed could have stated they will unwind their balance sheet at a rate equal to the demand of domestic and foreign investors, but they did not.

The securities’ dealers know that a country who can borrow in its own currency and has strict laws preventing its central bank from printing money, as the United States has, will experience deflation during recessions. This is why the economy deflated during the past two recessions and why it will deflate during the next. For those who understand, interest rates and Treasury yields fall during periods of deflation.

The securities dealers are being very patient, even though there is a low demand for U.S. Treasuries at the moment. Wall Street created many of the investment products and strategies used by investors today. Many of these modern strategies have automated mechanisms that sell stocks to buy bonds when volatility rises, which volatility tends to do when stock prices fall. There are currently trillions of dollars invested in these strategies which are mostly invested in stocks right now and which will shift into bonds when the next recession hits.

While the securities’ dealers may not be thrilled they are holding so many U.S. Treasury bonds, they know the demand for these bonds will exceed their supply during the next recession. When stocks fall again, like they did during the last two recessions, the dealers will be swapping their Treasuries for stocks, as investors tend to sell their stocks near the bottom of every market.

The securities dealers will eventually make a profit on their U.S. Treasury bonds, then make a profit when they sell the stock they bought at the bottom of the market back to investors when prices are high.

Just like casinos, the securities’ dealers hold the advantage. Investors have come up with many reasons to defend their view of the bond market, but all of them are based on inaccurate assumptions. The securities’ dealers may lose in the short run, but in the long run, global investors will flee to the safety of U.S. Treasury bonds, just as they always have done. During the next recession, U.S. Treasury bonds will rally in price as disinflation consumes the economy and global investors will do what they always have – sell stocks when they are low and buy bonds when they high.

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