Treasury Demand May Increase

Treasury demand may increase due to new Federal Reserve rules.

Demand for Treasuries is so great that investors are lending cash for next to nothing to obtain the securities as collateral through repurchase agreements, or so-called repos. The problem is market participants haven’t always delivered the bonds, causing “fails” to exceed $5 trillion at their peak, according to the New York Fed.

So, what's really going on here? The reason for the new rules is because some players are using Treasuries to gain leverage. It works like this (as far as I can surmise). Hedge funds buy Treasuries, and then borrow from the banks against them. They sign a repurchase agreement whereby the banks sell the Treasuries and agree to buy them back. However, they aren't always bought back; sometimes, they are just rolled over into a new agreement and the bonds don't change hands. So some enterprising managers have decided to sign repos with multiple banks in order to get free leverage. The Fed has decided to put a stop to it. A 3% penalty is high enough to stop this cold.

So, what are the implications? First, Treasury prices are likely to go even higher. Second, deleveraging of financial asset prices will continue. Third, this is deflationary for all assets except for Treasuries. Fourth, it will cut back on risk-taking.

These may sound like bad things, but they are not. I believe that this is a good and prudent rule from the Fed designed to instill confidence in contracts as well as force everyone to play by the same rules.

So, how does this change the way I view my portfolio? Not much. For the past month or so, the market has become much less volatile, government bailouts have neutralized some of the fear, there is some sort of consensus hope for an economic rebound in the second half of next year, new lows have not been made, and the market appears to have bottomed. Which makes me nervous because I'm so decidedly short against it, but at the same time, a change in sentiment back to bearishness will, I feel, provide a reward justifying the greater risk.

The bottom line is that deleveraging and deflation continue, and this is not a bullish macro environment for equities.

And now for another "bullish" story: "Clock Ticking on Benefits for Jobless SC Residents." Here's the setup:

A battle between South Carolina's governor and state officials over their unemployment fund threatens to cut benefits to about 77,000 jobless
residents as early as Thursday.

The state fund is set to run dry by the end of Wednesday unless they can settle on an agreement for the state to tap into a $146 million federal
loan. The loan would keep the benefits coming through March.

And here's the kicker:

The state's trust fund has been losing money for years as annual payments have exceeded the amount businesses pay in unemployment insurance taxes.

Of course this is "bullish"! Everyone knows that higher unemployment insurance taxes will come down the pike, increasing employment, making businesses more profitable, and generally contributing to an economic rebound. (smirk)

Dow 4000 in 2009.