On a steamy July morning in New York recently, the US Federal Reserve, in accordance with announced plans, began purchasing $3bn in government bonds maturing between February 2021 and 2026.
Prices rose in anticipation of the Fed move.
Some two hours later, the US Treasury auctioned $39bn in five-year notes.
Prices for government debt dipped on expectations of increased supply.
So goes another day in the market for US government securities. The Fed buys debt to support the markets while the Treasury auctions debt to pay for government spending.
Wall Street stands in the middle, taking its cut every time. In recent months, that cut has been sizeable.
The new world of government debt trading has been marked by the widening of spreads between bid and offer prices – the stuff of Wall Street profitability – following the demise of Lehman Brothers.
There are fewer primary dealers through which government securities are bought and sold – 18 compared with 31 a decade ago – and they are more likely to focus on handling customer orders than putting their own capital at risk.
With the average trading volume for Treasuries having fallen to $390bn a day from $566bn in 2007, trading with the Fed itself has become a more important part of the business. Fed behaviour figures heavily in how securities are priced.
If, for example, the Fed does not own much of a given Treasury issue, that issue is likely to be more expensive than comparable issues, reflecting the expectation that the Fed will soon purchase more, market participants say.
Taking advantage of such insights has become an important way for Wall Street to make money.
Just how much Wall Street makes on trading with customers, including the Fed, is hard to calculate, dealers say.
Debt trading profits are especially tricky to calculate but there is no doubt that they grew as a percentage of Wall Street revenues in the second quarter.
Goldman Sachs made $6.8bn on its fixed income, currency and commodities trading in the quarter, which David Viniar, chief financial officer, attributed to “historically wide margins” and a “fragmented credit environment”.
Such lucrative conditions are in marked contrast to two years ago when banks made money by using their own capital to trade.
Brad Hintz, an analyst at AllianceBernstein, says: “We won’t have narrow spreads ever again because there won’t be as much leverage ever again. It is a customer-flow model like in the nineties now.”
Additional reporting by Michael Mackenzie in New York
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