Steve Blitz Morning Notes

In the excellent tongue-in-cheek commentary in which Caroline Baum on Bloomberg excels she notes today that the days of the bond trader, specifically the government bond trader, may be coming back to its heyday of the 1980s. Back in this time of interest rate volatility and huge and growing budget deficits relative to GDP (kind of like today, but the Reaganites choose to forget all this) everyone was clamoring to be a primary dealer and get in on the action. Of course what is profitable today is not true about tomorrow and if there is one thing the "Street" knows what to do is over invest in some part of the market, go over the falls with it, and then reinvent itself in order to get back to earning the margin that pays for the bankers yachts. She writes:

"Even as banks swallowed up other banks, events were conspiring to reduce the allure of primary dealership. The availability of brokers’ screens to non-dealers increased transparency and chipped away at bid-ask spreads. The Japanese invasion of the 1980s -- first as investors, then as primary dealers -- disrupted the cushy franchise of dealers, who socialized with one another and were known to get together to “coup” an auction (collusion by any other name).

Feast or Famine

Electronic trading increased liquidity in the market, making it cheaper and easier to buy and sell plain-vanilla Treasuries. Customer business became a loss-leader for primary dealers, many of whom reinvented themselves as proprietary traders to justify (and underwrite) their existence.

By the time the federal budget swung into surplus in the late 1990s, there were still 37 primary dealers sitting around picking their noses, worrying what they’d do in a world with no Treasury bonds. (Don’t laugh: This was a real concern, especially for the Fed in its conduct of open-market operations.)"

I remember lots of government salesmen and traders losing their jobs between 1987 and 1991 and, in fact, the late 1980s was the peak of broker/dealer employment in NYC. The Street recovered and employment grew as the firms found that next best thing -- high yield followed by securitization -- exploited it and eventually overinvested in labor and capital. So as firms go over the falls with the implosion of securitized markets, they are ready if not already deploying capital into the next best thing. Ms. Baum writes further --

"In a curious twist of fate, the Treasury finds itself facing monstrous financing needs with only a handful of primary dealers to underwrite the debt. . . . .

Back to Basics

The result has been a widening of bid-ask spreads, which means an opportunity to make money the old-fashioned way. The steep yield curve is an added inducement.

Dealers can buy, say, a 10-year Treasury note yielding more than 3 percent and finance it (borrow against the securities) at the overnight repo rate of 0.2 percent.

No wonder some broker-dealers are applying to the New York Fed to become a primary dealer. At least one dropout is looking for readmission.

Not only is it a good time to be a primary dealer, it’s a great time to be a bank -- assuming you aren’t one already. The Fed is practically giving money away to almost anyone that asks."

The Street gravitates to where demand is growing faster than inventory and both are growing rapidly. There is lots of Treasury inventory here with more on the way and lots of demand given all the cash on the sidelines and the return of a trade deficit once GDP turns positive. Further, because rates are so low the derivatives geniuses will now be figuring low cost ways to cover the downside risk once interest rates begin the inevitable climb. How about a product pooling longer-dated Treasurys and then breaking it up into tranches with different sensitivities to interest rate risk. Before everyone gets up in arms remember this -- the government must know that it can't put an end to this behavior at the same time that it is flooding the system with cash and debt.