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Bond rally is squeezing the trading at big banks

Wall Street's biggest firms this year made an extraordinary wager that they probably now regret.

Investment banks typically hold tens of billions of dollars of Treasury bonds on their balance sheets, enormous positions that can create trading profits if the prices of the bonds rise. But this year, the banks slashed those holdings, so much so that they actually had a negative position in government bonds in March, according to data from the Federal Reserve Bank of New York. The banks and their clients apparently grew so bearish about the price of Treasuries that they wanted no part of them.

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But it was the wrong trade.

Confounding many on Wall Street, prices of government bonds have risen solidly this year, reaping profits for those who continue to hold them. This, in turn, has helped push down interest rates across the economy, providing an unexpected boon to companies and individuals taking out loans. The interest rate on a fixed 30-year mortgage, for instance, started 2014 at 4.53 percent, but it is now down to 4.14 percent, according to data from Freddie Mac.

Lloyd C. Blankfein, chairman and CEO of Goldman Sachs Group, center, walks with Gary D. Cohn, Goldman's president and chief operating officer.
Daniel Acker | Bloomberg | Getty Images
Lloyd C. Blankfein, chairman and CEO of Goldman Sachs Group, center, walks with Gary D. Cohn, Goldman's president and chief operating officer.

The big bond-trading firms on Wall Street are now bracing for a bruising to their results.

In early May, a little more than a month into its second quarter, JPMorgan Chase warned that its trading revenue for the period was going to be down about 20 percent from the previous year. Then Citigroup said it expected trading revenue to decline by a similar amount in the second quarter. "The environment for all of the firms is quite difficult right now," Gary D. Cohn, Goldman Sachs's president, said last month.

United States Treasuries have benefited partly because government bonds in Europe have had much lower yields, a situation that is likely to continue even as the European Central Bank announces new measures.

For Wall Street banks, the problems with bond trading go far beyond one quarter's performance or one cut in interest rates.

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Fixed-income operations — the name for the segment that includes trading in bonds, currencies and commodities — have long dominated and defined Wall Street. Before the financial crisis, swing-for-the-fences bond traders, amplifying their bets with cheap borrowed money, often earned billions for themselves and their firms. Fixed-income operations were the source of big losses in 2008, prompting Congress to pass many new regulations to rein them in.

Despite the new rules, Wall Street banks for some years after the crisis continued to make immense sums from fixed income — and they were upbeat about the business's prospects. The good results were in part due to the Fed's huge bond-buying programs aimed at stimulating the economy. But in the last couple of years, even as the world's big central banks have continued their stimulus plans, the revenue from Wall Street's fixed-income desks has dwindled. In the first quarter of 2010, the five top American bond-trading banks posted $24.8 billion of combined fixed-income revenue, according to Moody's Investors Service. In the first quarter of this year, the five generated only $14.6 billion of fixed-income revenue.

The drop-off has prompted much speculation.

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New regulations are in part to blame, analysts say. A new bank capital rule, for instance, has made it less attractive for Wall Street firms to make loans to clients to buy bonds. "There is structurally less leverage to go around," Richard Ramsden, a bank analyst at Goldman Sachs, said, using the Wall Street term for borrowing. At the same time, he said, Wall Street's big clients simply might not want to borrow as much they did.

Indeed, some large investors have been caught off guard in recent months. They positioned themselves at the start of the year for a fall in bond prices, analysts say. But as that decline failed to materialize, the investors had to offset their negative bets by buying bonds, pushing their prices up even more.

At the same time, bankers say, trading volumes have fallen because clients are struggling to come up with big new trading ideas in markets that they perceive to be predictable. Volumes might pick up, for instance, if investors chose to bet heavily against bonds as they rose. But, for now at least, investors apparently lack the confidence to make contrarian wagers. "You need the volume that comes with the conviction that someone else is wrong," Jim Vogel, a strategist at FTN Financial, said.

The malaise in bond trading does not appear to be serious enough to destabilize Wall Street, which, with higher levels of capital than before the crisis, is on a firmer footing. Also, banks are relying on the performance of staple businesses like mergers and acquisitions and wealth management, which is profiting from a strong stock market.

The weakness at bond-trading desks also does not appear to have affected the wider economy. Wall Street firms, for instance, continue to arrange the issuance of new bonds for companies and municipal governments. Corporations use the bond market to raise money for investments, and so far this year, American nonfinancial companies have issued $281 billion in bonds, according to Thomson Reuters. The lower interest rates have also contributed to a $100 billion increase in bank loans to companies this year, according to Fed data.

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The strong growth in credit, along with the Fed's stimulus, has convinced some investors and economists that the bond rally could soon end. The economy, they said, looks set to grow more strongly, which would most likely lead to somewhat higher expectations of inflation. "I think the U.S. economy is going to be very strong in the second and third quarters, and I don't see the inflation creep reversing," said Paul Kasriel, an economic adviser at Legacy Private Trust Company.

If inflation expectations increased, investors would start to adjust their portfolios. They would sell bonds, pushing down their prices and increasing their yields. This might in turn lead to a rush of trading that would lift Wall Street volumes. And the banks that have negative positions in Treasuries would profit.

But there have been several false dawns since the crisis, which has convinced some big investors that the economy is stuck in a rut, and they are betting that bond yields will stay at historically low levels.

That is the stance of Lacy H. Hunt of Hoisington Investment Management, based far away from Wall Street in Austin, Tex. One big mistake people have made, he asserts, is believing that the Fed's extraordinary monetary policies would lead to strong economic growth.

"The general overwhelming consensus is that central banks are powerful — and they are not," Mr. Hunt said. "They are out of the game."

By Peter Eavis, The New York Times

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