As we first pointed out [5], yesterday's stunning, near-failure in the 4-Week Bill auction, was the straw that broke the illusion of the market stability's back and as even Goldman pointed out [6], led to the first true "fear-driven" drop in stocks. Today, things are getting from bad to worse, as it is not the Halloween Bill, but the October 17 issue that is getting Friendo'ed [7]as can be seen on the chart below - the 10/17s just hit 42 bps, a nearly 20 bps move in minutes!
[8]
But while disturbing, what is going on in cash is just the beginning of the story. It is the events shadow funding markets that could really light the fuse on fire.
Recall that in our post from Monday "With A Looming Debt Ceiling X-Date And Still No Deal, Here Is Another Trade Idea [9]", we said:
Repo investors [will] 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"
In other words, in addition to another very profitable pre-debt ceiling trade (repo yields are spiking) alongside our other prior recommendation [10]that has generated epic alpha in ten short days, it was only a matter of time before the surge in cash yields moved to the repo market. That time is today.
According to some, the main reason for the crush in 10/17 Bills is that this is the first issue to no longer be accepted as collateral by repo desks. Which means the cash contagion has finally spread to Repo. Sure enough, Stone McCarthy [11]confirmed just that:
The Fed funds rate again opened at 0.10% this morning. Prior to today, it had traded at 0.09% early every morning since September 9th except for last Monday ahead of quarter-end. Yesterday's Fed funds effective rate was 0.08%. It was 0.06% last Monday for quarter-end, but outside of that it has held between 0.07% and 0.09% since June 18th. The overnight GC rate jumped this morning to 0.15%, which is above even where it was for quarter-end. It is the highest the early morning GC rate has been since June 28th.
And of course, unless this waterfall contagion is stopped, next up come money-markets, broader repo markets, and ultimately a Lehman-like Ice-9 freeze as contagion grasps the entire shadow funding market at precisely the worst time possible. Will this happen: we don't know. We do know, that with every day that the debt ceiling remains unresolved, the possibility of such an Ice-9 outcome becomes exponentially greater.