For banks and brokerages whose trading desks have struggled to turn a profit in riskier bonds, stocks and commodities this year, the prospect of joining an elite club with special access to the booming Treasuries market is especially enticing.
That club, the list of so-called primary dealers maintained by the Federal Reserve, added two new members this week, bringing their number to 22: Bank of Montreal and Bank of Nova Scotia.
Primary dealers — a group of big financial firms such as Goldman Sachs, Morgan Stanley, JPMorgan Chase, HSBC, BNP Paribas and Deutsche Bank — are designated to trade directly with the Fed and are obligated to bid on Treasury debt sales. That has left them uniquely placed to profit from a combination of heavy government bond issuance, highly accommodative monetary policy and strong "safe haven" demand from investors spooked by a range of financial and economic concerns. All of that has generated healthy turnover in the $9.5 trillion Treasury bond market, with the primary dealers sitting in the middle of it.
Uncertainty about the euro zone's debt crisis and the global growth outlook, coupled with downward pressure on bond yields from the Federal Reserve's latest move to shift its portfolio of bonds into longer-dated securities, has fueled big price swings in recent months for Treasuries. That higher volatility can be tough for investors, but it generates revenues for dealers.
Meanwhile, the Treasury Department is selling record amounts of debt to cover its large fiscal shortfall when many other fixed-income products continue to suffer anemic supply, creating more business for primary dealers. And with the Fed committed to buy long-dated bonds, the obligation to bid for those bonds comes with the welcome knowledge that giant buyer will be there until mid-2012, boosting the value of the dealers' inventory.
"On a relative basis, the Treasury market probably is a brighter spot this year," said Brian Edmonds, head of interest rates at Cantor Fitzgerald LP in New York, one of the primary dealers.
Jeff Michaels, joint head of fixed-income Americas at Nomura Securities International in New York, also a primary dealer, said banks that do more business in liquid assets such as Treasuries could benefit more as investors increasingly use Treasuries to hedge against downside in other risky assets.
Earnings from the Treasury bond business are also a comfort for banks facing tighter regulations, rules that curb their capacity to profit from bold trading positions. The amount of money they can borrow to enhance their bets on stocks, commodities and other assets has been curbed, and some rules bars banks from using their own money to make bets on financial markets. Trading activity in various risky assets has also waned as investors have flocked to Treasuries to preserve cash.
Even the Fed's action to stimulate the economy is a double-edged sword. Its move to buy long-dated Treasuries aiming to lower long-term consumer and corporate borrowing added to the pains of banks as lower yields narrows the profit margin on loans and other investments.
"The low level of interest rates … makes it more difficult for the primary dealers to work for much of a spread," said Kevin Giddis, president of fixed-income capital markets at Morgan Keegan Inc.
"That means that they must carry more bonds, trade more bonds, and hope that what they own is in sync with what the Fed wants to buy. Net, I suspect that this isn't an especially profitable time to be a primary dealer."
