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With A Looming Debt Ceiling X-Date And Still No Deal, Here Is Another Trade Idea

Tyler Durden's picture




 

On September 26, when we wrote "As US Default Risk Spikes To 5-Month High, Here Is How To Trade The Debt Ceiling Showdown", we suggested a simple 1M/1Y Bill flattener, which has since resulted in a massive profit to those who put on the trade with appropriate leverage, leading to the steepest outright inversion the short-end curve has seen on record. For those who engaged in this trade, it may be time to book profits and move on, as the risk of a negative catalyst - a shutdown/debt ceiling resolution - gets higher with every passing day that we move closer to the October 17 X-Date. However, those who wish to remain engaged in the short end of the bond market where the highest convexity to the daily newsflow can be found, one possible alternative trade is to shift away from cash markets, and into shadow banking, via the repo pathway.

It is here that Barclays' Joseph Abate sees a substantial arbitrage opportunity, as "repo investors begin to focus on the underlying collateral" and "start to make a distinction between debt that is most subject to payment delay and paper that is not." The result would be that as cash leaves the funding market, "the financing rate on all Treasury collateral – regardless of its maturity cycle – will rise." Indeed, during the last debt crisis in the summer of 2011, Overnight repo soared from 1 bps to 28 bps in the span of a few weeks. It is this trade that may once again generate substantial alpha for those who wish to bet on continued Congressional dysfunction because the October US Treasury repo future is currently trading at an implied yield of just over 11bp, having cheapened by more than 3bp since September 23. "Depending on how quickly the debt ceiling is raised, we expect this implied yield could move higher ahead of October 17" Barclays concludes.

Full note for those who are brave enough to fight if not the Fed, then certainly the specter of a congressional compromise:

1m bills have cheapened from barely 0bp (there were some negative rate trades a week ago) to 14bp on Friday morning. This sharp cheapening reflects the fact that while investors believe the US Treasury will not default and the risk of a delayed payment is extremely low, they are unwilling to take any chances. As a result, the 4wk bill is now trading about 4bp higher than the year bill and about 10bp above the 3m bill. Judging from the behavior of this market in July 2011 when the debt ceiling negotiations were last this intense, 4w bill yields probably have some more room to rise. Assuming the debt ceiling is not increased this weekend, we expect the 4w bill could reach 17-20bp by early next week.

 

Primary dealers also appear to be taking no chances. In the week ending September 25, they reduced their bill inventories by more than 50% to just $20bn. We expect next week’s release will reveal a similarly sharp decline in bill holdings.

 

Repo investors are also extremely risk averse. Our sense is that some investors, seeking to avoid the risk of payment delays on underlying collateral, may move away from the repo market entirely. As cash leaves the funding market, the financing rate on all Treasury collateral – regardless of its maturity cycle – will rise. Overnight Treasury repo was trading around 1bp in July 2011, but as the critical August 2, 2011 deadline approached, collateral rates began moving higher – rising to 28bp on August 1. The October US Treasury repo future is currently trading at an implied yield of just over 11bp, having cheapened by more than 3bp since September 23. Depending on how quickly the debt ceiling is raised, we expect this implied yield could move higher ahead of October 17.

 

As repo investors begin to focus on the underlying collateral, we expect they will start to make a distinction between debt that is most subject to payment delay and paper that is not. The Treasury coupons most sensitive to a payment delay or a maturity extension are those with a payment due on the late October/April cycle. There are 23 coupon CUSIPs in this series – totalling $773bn. Of these securities, $135bn are held by the Federal Reserve in its System Open Market account. At the end of August, money market funds held just over $6bn worth of April 30, 2014 debt. They held another $24bn worth of bills (or short coupons) maturing on October 31, 2013.

 

Finally, as the debt ceiling negotiations continue, we expect some money to start flowing out of government-only money funds. Like other investors in the front end, these investors – although they attach a small probability of a Treasury payment delay – are unwilling to risk a “buck-breaking” event in their funds. In the run-up to the August 2011 debt ceiling increase, government-only money fund balances declined by 10% – in roughly a week. So far, however, these money fund balances have been very stable with few signs of a pick-up in redemptions.

It goes without saying that once the debt ceiling is increased, all such distortions will quickly reverse.

Of course, if the Treasury does go through the X-Date with no deal in store and ultimately succumbs to a technical default, the question of who owns what paper securities and has paper P&L, will become irrelevant, as all attention will very quickly shift solely and exclusively to physical assets.

 

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Mon, 10/07/2013 - 13:06 | 4030839 Headbanger
Headbanger's picture

Better yet,  A tornado watch is posted for DC today and maybe it'll wipe out the whole mess for us:

http://liveblog.wtop.com/Event/Tornado_watch_posted_for_DC_metro_area

Mon, 10/07/2013 - 13:06 | 4030844 fonzannoon
fonzannoon's picture

"It goes without saying that once the debt ceiling is increased, all such distortions will quickly reverse."

where would that put gold?

Mon, 10/07/2013 - 13:16 | 4030901 Grande Tetons
Grande Tetons's picture

Gold would get slapped below 1300. Where it would bob around a bit more while the Chinese and other easteners buy more. 

 

I hope they default. I am getting bored. 

 

Mon, 10/07/2013 - 13:24 | 4030928 seek
seek's picture

I think it's established now that no matter the event, gold gets slammed. I think the only exception would be a real, honest-to-god default, which ain't happening this year.

Mon, 10/07/2013 - 13:33 | 4030969 TheGardener
TheGardener's picture

"honest-to-god default" must not happen this century or next,
it takes time for formerly formidable empires to wind down
so betting on god send King`s money is an eternal and not just long term bet.

Mon, 10/07/2013 - 13:33 | 4030974 JenkinsLane
JenkinsLane's picture

I'd say it would head towards a re-test of the June low. Moreover, if you couple 

the traditional December spanking with Taper On it could be pushed towards $1000.

 

Mon, 10/07/2013 - 13:11 | 4030850 One And Only
One And Only's picture

If we go past the X date don't worry about buying anything. Take the cash out of the mattress and hide under the bed. Never come out again. Everyone says it will be too scary so have a familiar blankey to keep you safe. Buffet even said as bad as nuclear bombs so literally millions could die in 1 second should the ceiling not get raised. Shelter in place

Mon, 10/07/2013 - 13:15 | 4030893 Bobbyrib
Bobbyrib's picture

How will the Orifice of Omaha get his government subsidies without an increase in the debt ceiling?

Mon, 10/07/2013 - 13:14 | 4030866 Ham-bone
Ham-bone's picture

During 2012, Treasury issued following debt-

Notes (less than 1yr)- $708 B ($7.7 T in total public debt existing)

Bills (2yr to 10yr) - $137 B ($1.6 T in total public debt existing)

Bonds (30yr) - $178 B ($1.4 T in total public debt existing)

TIPS - $102 B ($900 B in total public debt existing)

Please note Fed purchased no Notes, and bought $480 B in Bills, Bonds (not sure on TIPS???) but Feds focus on longer duration means Fed is buying $480 B of a possible $417 B in new issuance...or put another way the Fed is buying @ 120% of Treasury longer dated issuance (if TIPS are not Fed purchased, then Fed is buying @ 160% of Bill / Bond issuance).  Think on this a little when tapering is being discussed.

Shit, there's only $3 T in public debt in Bills / Bonds...Fed already has $2.2T???  Is Fed now buying from intragovernment holdings???

Mon, 10/07/2013 - 13:11 | 4030867 Seasmoke
Seasmoke's picture

Let Obama choose the cup without the poison. 

Mon, 10/07/2013 - 13:15 | 4030886 kralizec
kralizec's picture

Heh!

"The pellet with the poison's in the vessel with the pestle; the chalice from the palace has the brew that is true!"

Mon, 10/07/2013 - 13:25 | 4030941 Headbanger
Mon, 10/07/2013 - 13:10 | 4030868 carbonmutant
carbonmutant's picture

If we go past Oct 17, you might want to take a little extra out of the bank...

Mon, 10/07/2013 - 13:11 | 4030874 drink or die
drink or die's picture

"Of course, if the Treasury does go through the X-Date with no deal in store and ultimately succumbs to a technical default..."

 

At that point we would be more worried about the monkeys flying out of our butts.

Mon, 10/07/2013 - 13:14 | 4030887 Rot-10
Rot-10's picture

"It is this trade that may once again generate substantial alpha"

Taking on additional interest rate risk and credit risk in a search for yield does not result in alpha - at least not according to my standards.  But I like the idea!


Mon, 10/07/2013 - 13:19 | 4030903 JenkinsLane
JenkinsLane's picture

Here's how to trade the debt ceiling - don't bother. Just wait until it is resolved, which it will be sooner

or later, then be Johnny-on-the-spot when the deal is announced. Short the PM space, short vol, go long

the broads, etc.

Mon, 10/07/2013 - 13:33 | 4030924 TalkToLind
TalkToLind's picture

Government of the people, by the people, for the people is one of the most deceitful marketing slogans ever devised.  It is a lie.  For the patriots who still believe that for the people nonsense,
read this:  http://www.ktnv.com/news/local/Lake-Mead-Property-Owners-Forced-Out-Until-Gov-Shutdown-Ends-226557661.html

and this: http://www.powerlineblog.com/archives/2013/10/shutdown-theater-mount-rushmore-edition.php

Mon, 10/07/2013 - 13:26 | 4030946 luna_man
luna_man's picture

 

 

Piling onto my already "short" positions... "CRIMINALS", OWE ME PLENTY!!

 

wish me luck boy's

Mon, 10/07/2013 - 13:36 | 4030981 Bastiat
Bastiat's picture

 

 

Slightly O/T and apocryphal but plausible:

Putin on Obama, off the record:  "Negotiating with Obama is like playing chess with a pigeon. The pigeon knocks over all the pieces, shits on the board and then struts around like it won the game."

Mon, 10/07/2013 - 13:54 | 4031083 TheGardener
TheGardener's picture

Insert "modernity" into pigeon and you have my hive mind on board..

Mon, 10/07/2013 - 13:57 | 4031080 DavidPierre
DavidPierre's picture

Financial analyst Dr. Jim Willie says forget about the government shutdown and the debt ceiling.

It is the Treasury market that is the big problem.  Dr. Willie says, “What’s going on with the Treasury bond market right now is systems are breaking . . . they broke the interest rate swaps.  They are not functioning anymore. . . . Foreigners are dumping Treasuries.” 

Dr. Willie contends this is what caused the spike in interest rates in the past few months.  And what was the meeting last week of all the big bankers at the White House? 

Dr. Willie speculates, “I think it was an emergency meeting because they cannot successfully defend the dollar anymore, not fend off the big Treasury bond sales.” 

Dr. Willie thinks, “Reversal in the Treasury bond market could be a death blow for these zombie New York banks . . . These big banks are in danger of imploding”   

Dr. Willie predicts, “I don’t think the Fed is going to taper its bond buying.  I believe they are going to double it.” 

Dr. Willie goes on to say, “The Fed will say let’s continue QE, and instead of suffocation from rising rates, we’ll have drowning from rising costs. . . . They are going for drowning because it’s slower.” 

http://usawatchdog.com/systems-are-breaking-in-treasury-bond-market-dr-j...

Mon, 10/07/2013 - 13:56 | 4031084 y3maxx
y3maxx's picture

Follow the "smart" money.....What are Congress members investing into?

Mon, 10/07/2013 - 14:03 | 4031115 Winston Churchill
Winston Churchill's picture

The NSA helpline is closed so we don't know where 'our' congreecritters

are putting down their chips.

Mon, 10/07/2013 - 14:00 | 4031107 traderjj57
traderjj57's picture

Trade idea, this market is long past using actual ideas, there is no competing with the criminal element.

Mon, 10/07/2013 - 18:30 | 4032151 RMolineaux
RMolineaux's picture

This looks to me like more advice to the parasites who are looking to make money out of other people's misfortunes while the ship sinks.

Do NOT follow this link or you will be banned from the site!