Primary Dealers’ Bond Cuts Drain Liquidity: Chart

Wall Street’s biggest bond dealers are paring inventories of Treasuries to an almost three-year low, adding to concern diminishing liquidity will amplify yield swings when the Federal Reserve begins raising interest rates.

The CHART OF THE DAY shows the Fed’s 22 primary dealers cut positions in Treasuries in July to the lowest level since 2011 as they reduced holdings in every maturity sector less than 11 years, according to New York Fed data. Primary dealers, which are obligated to trade with the central bank at auctions, trimmed their holdings to $18.3 billion in the week ending July 16, down from $27.7 billion the previous week and a record $146 billion in October.

“It could be dangerous because there won’t be huge enough balance sheets to absorb huge moves in the market,” said Brian Edmonds, head of interest-rates trading in New York at primary dealer Cantor Fitzgerald LP. “That risk appetite won’t be as good as it has been in the past.”

Dealers have also reduced holdings as they attempt to meet a 5 percent capital requirement under revised supplementary leverage ratio rules. The ratio, which is a gauge of capital compared with a bank’s assets, eliminates risk weighting and some advantages to holding Treasuries. It is required by 2018 under U.S. regulators’ proposed rules.

Traders see about a 59 percent chance the Fed will raise the target for its benchmark to at least 0.5 percent by July 2015, based on futures contracts. Fed Chair Janet Yellen has indicated the central bank is likely to raise interest rates next year, following the completion of the debt-purchase program in October.

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