Bond Talk With a Veteran Credit Trader

Just a quick note.


I wanted to share a conversation I had today with a veteran bond trader who has been on the street for decades. Let's take a look at the bond auctions today:


My Take:

As you can see above, the first auction was pretty ugly. The Primary Dealers were forced to buy up about 65% of the auctions. The bid to covers were respectable on both auctions.

Now lets get into my discussion with a my veteran bond trading source. He believes that the PD's aren't exactly being forced to buy these auctions. In fact, they most likely want to own of these bonds in the current trading environment.

Why?

He explained an classic old school Wall St bond game to me that's been going on for decades:

Basically, the bond market will often sell off treasuries for several days before an auction so that they can pick up the treasuries on the cheap at the auctions. They then turn around and make a nice spread on them when the auctions get done because treasuries usually rise once the auctions are closed out and the BTC is acceptable.

The bond traders make a nice spread once the treasuries rise post auction because they can sell what they bought at a higher price.

He explained that this is one of the reasons why Wall St trading profits have been so astronomical recently. He added that the major players in this game like Goldman are thriving in this environment, and they are also benefiting from less competition with Bear Stearns and Lehman out of the mix. Lehman was a major player in bonds.

As a result, with less competition and high volatility in bonds, Wall St is thriving(for now) as they participate in these auctions.

If you look at what yields did last week heading into the auctions today, it appears my source is dead right. Treasuries sold off hard as the 10-year yield soared to almost 3.9% by Friday. This allowed the PD to gobble up treasuries on the cheap at today's auctions. They then simpply turn around and sell them at a tidy profit as treasuries rose and yields dropped during the day.

A case could be made that high PD participation in these auctions could actually be bullish in the near term because the primary dealers are able to trade them so effectively. Remember folks, there is still a ton of demand for treasuries by people like us. Many want no part of the stock market right now so the Primary Dealers have plenty of cutomers to sell to.

Don't get me wrong, I believe the world is backing away from our debt. However, its not happening in droves yet, and this sets up a highly volatile trading environment in bonds where good bond traders can make a fortune.

This trade(for now) is working most of the time unless the BTC is awful(which is rare).

The Bottom Line:

Wall St is a mighty smart bunch of thieves, and they are finding ways to make money in this market. I still believe that the bond market will eventually collapse as a result of the massive deficits that we are running.

For now however, Wall St is laughing all the way to the bank as they use your taxpayer dollars to make billions in stocks and bonds.