As Barclays' Joe Abate warns, delivery fails in the Treasury market have surged recently. While not at the scale of the 2008 crisis yet, we suspect the spike is what is panicking the Fed to say "the market is wrong", talk up short-end rates, and implore the public to sell-sell-sell their bonds. The Fed's market domination has meant massive collateral shortages (as we have detailed previously [7]) and now more even that during last year's taper-tantrum, the repo market is trouble.
The fails are greater than during last year's taper tantrum.
[8]
But well below the 2008 crisis levels (for now)
[9]
Which is why The Fed is in panic mode to get everyone selling bonds.
As Abate write in his note,
Delivery fails in the Treasury market have surged recently. On Monday, the DTCC reported that incomplete deliveries reached a 52-week high at $120bn (Figure 1). And a week earlier, Treasury fails – as measured by the Federal Reserve – exceeded 6% of daily dealer Treasury transactions volumes. By contrast, usage of the Fed’s securities lending program has been relatively constant at around $15bn/day. Recall that each day the Fed auctions securities from its securities portfolio (at a 5bp fee) for dealers to borrow overnight to cover their shorts. In effect, the securities lending program is a backstop source of specific issue supply that dealers can access temporarily to prevent market disruptions caused by fails or incomplete deliveries.
But what if the Fed does not own any of the issues that dealers need? Indeed, this appears to be driving the surge in recent fails, which have been concentrated in the OTR 5s and 10s. Operation Twist and the sale of all the Fed’s <3y paper has meant that the Fed does not own any securities that mature until early 2016. Without maturing paper, the Fed is unable to buy OTR issues at Treasury auctions. The fact that the OTR issues are trading special in the repo market also means that the Fed avoids buying these securities in its (diminishing) QE purchases.
[10]
In the absence of Fed supply, dealers face a choice: fail and pay a 300bp fee for not completing the promised delivery or offer a sufficiently low financing rate to coax supply of the issue back into the market. In effect, the 300bp fails charge becomes the threshold determining how rich an issue will trade in the repo market or whether it will fail.4 Regularly scheduled re-openings and supply lured in from customer holdings in lendable accounts will eventually cheapen these issues. But in the meantime, the issues are likely to trade deeply special.
A quick reminder of what the repo market is... (via IMF) [11]
Think of the bilateral repo market via the analogy for old clothing trade: Typically, merchants in developed countries shrink wrap old clothes in shipping container sized bundles (under pressure) and send the plastic wrapped block to poor countries. There, a clothing broker buys it, and resells it by weight to jobbers. So if the block weighs 500 pounds and they sell it in 10 pound lots, all 50 people gather around. But some people pay slightly more to be at the front of the crowd, and some pay slightly less to be at back. Then the jobber pops the bundle open with a big knife and the shrink wraps literally explodes; everyone gathered around jumps for the best pieces.
Collateral desks are a bit like those jobbers. Big lots come in from hedge funds and security lenders, and the large bank’s collateral desk paws through it, searching for gems. Those gems go out bilateral to customers who'll pay a premium. The remainders go to the guys in the back of the line (for example, triparty repo)
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But why do I care about some archaic money-market malarkey? Simple, Without collateral to fund repo, there is no repo; without repo, there is no leveraged positioning in financial markets; without leverage and the constant hypothecation there is nothing to maintain the stock market's exuberance (as we are already seeing in JPY and bonds).
Crucially, it should be inherently obvious to everyone that the moves we see in the stock market is not about mom and pop choosing to invest in the stock market (or not) as the 'cash on the slidelines' fallacy is "completely idiotic' but about the marginal leveraged machine (or human) quickly jumping oin momentum.
The spike in "fails to deliver" highlights a major growing problem in the repo markets that provide that leverage... and thus the glue that holds stock markets together.
Wondering why JPY and bond yields have diverged so notably from stocks in recent days... repo effects (it's just a matter of time before it hits stocks)...
[12]
So that explains why the Fed is so desperate to talk you into selling your bonds - most notably the short-end by demanding you listen to what Yellen said about raising rates.. as that reduces the shortfall of collateral that repo needs and restocks the banks with repo-able funds.
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Is that why a noted dove like Jim Bullard was so visibly hawkish yesterday? [13]
The irony of course of the Fed explaining how rates will rise faster is that it spooks stock investors who have grown used to exuberant liquidity supply and roitates them to bonds... which merely exacerbates the problem the Fed has
