As we have discussed at length, the issue of the surge in Treasury fails (and the Fed's panicked "sell your bonds" response) [6] suggests things are far less 'stable' than they would like the world to believe. Simply put, "Repo Matters" as Alhambra's Jeffrey Snyder discusses below [7]:
The current repo fails problem “directly rebukes” the idea that the Fed has “all possible scenarios covered.”
- For the Fed to have all scenarios covered would mean that the NY Fed’s SOMA portfolio has to maintain a “broad enough inventory” to satisfy the market
- “That, on its face, is a patently unrealistic assumption since it will be impossible to predict exactly what repo markets need in even the immediate future, let alone during any drawn out ‘normalization’”
- Recent spike in repo fails is important because RRP is supposed to “directly alleviate a collateral shortage of this kind”
- To lose control of short-term rates during an anomaly would be “potentially dangerous” especially if it were to take place during “normalization, where instability would be beyond elevated”
- Where the Fed failed to “enforce a floor during the worst days of panic in 2008 and into 2009” there is “much confidence here that flaws have been found and addressed positively”
The question for financial participants is whether or not a less solid and shrinking repo market is unrelated to continuous and orderly function. History suggests, decidedly, it is not.
For central banks, it seems to follow that they are content, at least outwardly, to simply manage expectations with the idea that will be enough to create and maintain “resiliency.”
By persisting with the PR campaign that the world is fixed and close to attaining near-perfection that is supposed to be enough to offset very real weakness in liquidity and emergency balance sheet capacity? Then again, if you actually believe that of the economy and markets then the chances for a financial “shock” are probably trivial in your estimation. But it pays to remember that last year’s bond selloff was also “unexpected” as well.
It’s not exactly the idea of currency elasticity imagined when the Fed was first dreamed up, but then again that function was also mostly PR.
As Snyder concludes,
The FOMC wants, actually needs, to instill confidence that it can transform itself from its QE legacy (however much tarnished it has grown). This only heightens the idea that stability is a paperlike illusion that may be undone with only the slightest “shock” or disruption – the hidden asymmetry that is the hallmark of fragility. This severely, in my opinion, undermines the credibility of even the idea of the rate floor.
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The Fed's market domination has meant massive collateral shortages (as we have detailed previously [8]) and now more even that during last year's taper-tantrum, the repo market is trouble.
* * *
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)...
[9]
And while the world breathlessly ignores it because stocks are going up for now, here's what it meant in 2009 [10]:
“If you have fails, then the market isn’t functioning properly,” said Eric Liverance, head of derivatives strategy at UBS AG in Stamford, Connecticut, another primary dealer. “That is what we saw last fall when we had massive fails. If you can lend a bond out and count on it coming back the next day, then those are properly functioning markets and it enhances liquidity.”
“That is telling you that dealers really don’t know what all this will mean,”
“People are being prudent and saying I am not going to have a Treasury short now and I’ll wait to see how this pans out over the next two months.”
“The market’s heightened state of anxiety looks likely to produce unintended and unfortunate consequences,” said Ciaran O’Hagan, the Paris-based head of fixed-income at Societe Generale. “The fails penalty adds to the security of the market at the cost of liquidity. All this suggests that liquidity will be hurt across the board for U.S. Treasuries.”
