Traders see slim pickings with new rule

“Quarterly” is something of a misnomer, seeing as how the government had to shift to semi-monthly refinancing to accommodate huge borrowing needs. Bond traders cling to the old terminology, a reminder of the days when they could throw their weight around.

Selling US$125 billion of Treasury notes and bonds in a week isn't easy, what with yields skyrocketing, the dollar tanking, foreign central banks balking and institutional investors sitting on the sidelines.

On cue, the undersecretary for domestic finance assures us the Treasury “will have no trouble selling its debt.” The only question is the price.

The 30-year bond trades at a yield of 8.77 percent in the when-issued market, 90 basis points higher than at the previous month's sale. The volatility has scared investors away while the Volcker Rule banning banks from proprietary trading has whittled the number of primary dealers down to eight.

The bidding is all over the place, and the US$26 billion of bonds are awarded at a yield of 8.93 percent.

Fantasy? Yes. Could it happen? Probably not. Is there a message in the story? Of course. Otherwise, why would I waste my time?

The Treasury isn't about to undermine its debt sales with rules that handcuff dealers from participating in auctions.

Still, writing rules that prohibit banks from speculating with federally insured deposits — a sound goal — isn't as easy as the Obama administration thinks.

In the old days, there was a clear dividing line between customer and proprietary trading. A trader servicing customers (institutions, not moms and pops) provided liquidity: a price at which he would buy or sell a given security. He could buy bonds on the bid side and sell them on the offered side and pocket the difference.

A prop trader bet on the direction of the market and spread relationships (cash bond vs. bond futures, two-year vs. 10-year, bond vs. old bond) and generally had a longer time horizon. The prop trader is looking for movement.

As the number of primary dealers soared to a peak of 46 in 1988, bid-ask spreads narrowed. Once buy-side customers had access to brokers' screens — the inside market — the spreads evaporated. Every trader became a prop trader because there was no money in making a market in two-year Treasury notes.

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