Repo Market

The day when the Fed will begin the unwind of its latest QE program (for the fourth time) has finally arrived (as has the day when an impeachment committee will vote whether to ban Berlusconi from public office, but understandably that is getting far less press). In a few short hours the answer to all those questions of whether and how much of the taper was priced in, will be revealed. But while the Taper discussions will dominate the airwaves, as they have for the past five months, there actually were some news in the world that had nothing to do with the US Politburo in charge of capital markets and the US economy, located in the Marriner Eccles building. Here is a brief summary.

Much has been said about the recently announced (with the release of the Fed's July Minutes) proposal for a full-allotment overnight reverse repo facility, some of it confused, some of it desperate to read deeply into what the Fed is suggesting with this superficially tightening process, and most of it just plain wrong. What the Fed is simply trying to do with the O/N RRP, in a few words, is alleviate collateral pressures for "high-quality assets" - the same thing that the TBAC has been whining about for the past 2 quarters - by making available an elastic supply of risk-free assets to a fairly broad set of investors. As BofA adds, "The full-allotment feature would mean that eligible investors could effectively place as much cash as they wished at a fixed rate, which would be determined in advance by the Fed." In brief, a Fed O/N RRP facility would substantially reduce or even eliminate concerns about the lack of high quality liquid assets.

It’s ironic, or it seems that way to us, that two of the least understood financial markets by equity investors are two of the most systemically important – repos and gold. Even more ironic is how so many investors don’t even consider them to be all that important. In our view, stability in both markets is a pre-requisite for maintaining confidence in the financial system and keeping the credit/asset bubble inflated. The significance of these markets is not lost on governments, central banks and regulators, although the definition of “stability” in each of them is slightly different. Looking underneath the bonnet/hood, we are doubtful that either of these markets, repos or gold, can reasonably be described as “stable” right now. There also seems to be a paradox where the current low repo rates and gold prices are, we suspect, fooling people into a false sense of complacency. What’s really piqued our interest, however, is whether there is a similar issue which is increasingly impacting both of these systemically important markets? This issue relates to the availability of sufficient collateral...

THE RESULTS OF THE 5-YEAR NOTE AUCTION COULD RESULT IN THE UNSCHEDULED REOPENING OF THE 7-YEAR NOTES OF SERIES P-2018 (CUSIP NO. 912828RE2)

If the auction of the 5-year Treasury notes to be held Wednesday, August 28, 2013, results in a high yield in a range of 1.500% through and including 1.624%, the 5-year notes will be considered an additional issue of the outstanding 1-1/2% 7-year notes of Series P-2018 (CUSIP No. 912828RE2) originally issued August 31, 2011. The additional issue of notes would have the same CUSIP number as the outstanding notes, which are currently outstanding in the amount of $29,886 million. If the auction results in the issuance of an additional amount of the outstanding 7-year notes rather than a new 5-year note, it will be indicated in the Treasury's auction results press release and by a special announcement. Any net long position reporting in this auction should be in regard to the 5-year notes.

It's all about rates this largely newsless morning, which have continued their march wider all night, and moments ago rose to 2.873% - a fresh 2 year wide and meaning that neither Gross, nor the bond market, is nowhere near tweeted out. As DB confirms, US treasuries are front and center of mind at the moment.... the 10yr UST yield is up another 4bp at a fresh two year high of 2.87% in Tokyo trading, adding to last week’s 20bp selloff. As it currently stands, 10yr yields are up by more than 120bp from the YTD lows in early May and more than 80bp higher since Bernanke’s now infamous JEC testimony. We should also note that the recent US rates selloff has been accompanied by a rapid steepening in the rate curve. Indeed, the 2s/10s curve is at a 2 year high of 250bp and the 2s/30s and 2s/5s are also at close to their highest level in two years.

For many years, we have been extremely focused on shadow banking and most specifically the repo markets (recently here and here). Most market participants will go through their trading life ignorant of the fact that the leverage in this market is what drives their assets up or down in most cases (because understanding something new is so 'old normal' even if it remains a major potential catalyst for problems ahead). The regulators get it though (kinda). As Barclays notes, changes to the risk-weightings of low-risk assets in the repo markets means US banks will need to deleverage by raising $30bn of fresh capital or reducing their (mostly low-risk) assets by $598bn - not chump change in a market dominated by the Fed (and one that some have already raised default and liquidity concerns about).

First it was the TBAC's May presentation "Availability of High Quality Collateral" piggybacking on reasoning presented previously by Credit Suisse. Then JPM's resident "flow and liquidity" expert Nikolaos Panigirtzoglou rang the bell on regulatory changes to shadow banking and how they would impact the repo market and collateral availability (and transformation) in an adverse fashion. Now, it is the turn of Barclays' own repo chief Joseph Abate to highlight a topic we have discussed since 2009: the ongoing contraction in quality collateral as a result of transformations in shadow banking and the Fed's extraction of quality collateral from traditional liquidity conduits (i.e., QE's monetization of bonds). To wit: "Several recent regulatory proposals will increase the pressure on banks to reduce assets that carry low risk weights. Repurchase agreements are a large source of banks’ low-risk assets, and we expect banks to reduce their matched book operations in response to these proposals."

One year on from the "whatever it takes" speech and all appearances suggest Draghi's all-in move with the imaginary OMT 'worked. European sovereign spreads have compressed dramatically, European stock indices are near their highs, European financials are doing great. Of course, record unemployment rates, record loan delinquencies, record drops in house prices, and record deposit outflows can all be ignored because no matter what, Draghi will do "whatever it takes." Except, as JPMorgan notes, the excess cash in the Euro area banking system continues to decline reaching EUR230bn, closer to the so-called inflection point at which money market rates, i.e. EONIA and repo rates, are responding more pronouncedly to changes in the excess cash. Bank funding is becoming increasingly volatile since the 2nd LTRO repayment and the trend shows no sign of abating. We suggest Mrs. Merkel will be on the phone telling Mr. Draghi to "get back to work," - at least until September 23rd anyway.

Excessive monetary stimulus and low interest rates create financial bubbles. This is the biggest debt bubble in history. It is a potent deflationary force and central banks are forced into deploying increasingly aggressive (offsetting) inflationary forces. The avoidance of a typical deflationary resolution to this economic long (Kondratieff) wave is pushing the existing monetary system beyond the point of no return. The purchasing power of the developed world’s currencies will have to bear the brunt of the “adjustment”. Preparations for this by the BRICS nations, led by China, are advancing rapidly. The end game is an inflationary/currency crisis, dislocation across credit and derivative markets, and the transition to a new monetary system. A new “basket” currency is likely to replace the dollar as the world’s reserve currency. The “Inflationary Deflation” paradox refers to the coming rise in the price of almost everything in conventional money and simultaneous fall in terms of gold.

As we warned here most recently, the shadow-banking system remains the most crisis-catalyzing part of the markets currently as collateral shortages (and capital inadequacy) continue to grow as concerns. In recent weeks, between The Fed, Basel III, and the FDIC, regulators have signalled the possible intent to change risk, netting, and capital rules that could have dramatic implications on the repo markets and now, it seems, the SEC has begun to recognize just how big a concern that could be. As Reuters reports, the SEC urged funds and advisers last week to review master repurchase agreement documentation to see if there are any procedures to handle defaults, and if necessary, prepare draft templates in advance. A retrenchment in repo markets is unwelcome news for the liquidity of the underlying securities and the impact on the derivative portfolios should not be underestimated.

Our "silver lining" concluding remark to last week's lackluster 10 Year bond reopening auction was that "the good news is that with the reopening, dealers should have some additional collateral for a while, or at least until the Fed monetizes it. Look for this CUSIP - VB3 (On The Run) to remain on the POMO exclusion lists for white a while." Sure enough, following the Friday settlement of this auction, things in the Treasury repo market have normalized somewhat after hitting very dangerous levels. How bad did it get? The following chart of failures to deliver from the NY Fed shows just how acute the shortage of "high quality collateral" (where the 10 Year is the fulcrum instrument) got in the past two months, with the total rising to $129 billion, or the biggest freeze in the repo market since the debt-ceiling crisis in the summer of 2011 when this number hit $280 billion.

Fractional reserve banking is unlike most other businesses. It's not just because its product is money. It's because banks can manufacture their product out of thin air. Under the bygone rules of free market capitalism, only one thing kept banks from creating an infinite amount of money, and that was fear of failure. Periodic bank failures remind depositors of the connection between risk and reward. What is not widely appreciated is that the ensuing government bailouts allowed an underlying shadow banking system to not only survive but grow even larger. To the frustration of Keynesians, and despite an unprecedented Quantitative Easing (QE) by the Federal Reserve, conventional commercial banks have broken with custom and have amassed almost $2 trillion in excess reserves they are reluctant to lend as they scramble to digest all the bad loans still on their books. So most of the money manufactured today is actually being created by the shadow banks. But shadow banks do not generally make commercial loans. Rather, they use the money they manufacture to fund proprietary trading operations in repos and derivatives. No one knows when the bubble will pop, but when it does a donnybrook is going to break out over that thin wedge of collateral whose ownership is spread across counterparties around the world, each looking for relief from their own judges, politicians, bureaucrats, and taxpayers.

"While certain types of rehypothecation can be beneficial to market functioning, if collateral collected to protect against the risk of counterparty default has been rehypothecated, then it may not be readily available in the event of a default. This, in turn, may increase system interconnectedness and procyclicality, and could amplify market stresses. Therefore, when collateral is rehypothecated, it is important to understand under what circumstances and the extent to which the rehypothecation has occurred; or in other words, how long the collateral chain is... Financial intermediaries should provide sufficient disclosure to clients when collateral assets posted by them are rehypothecated; rehypothecation should be allowed only for the purpose of financing the long position of clients and not for financing the own-account activities of the intermediary; and only entities subject to adequate regulation of liquidity risk should be allowed to engage in the rehypothecation of client assets."

Until the last few days, the attention of the mainstream business media has been on how 'wonderful' Japan's policy prescription must be since its stock market is soaring at a record pace. The reality is that the far bigger JGB market has been crumbling. As we explained here, this is a major problem for the bubble-blowers, as the extreme volatility (VaR shock) that the Japanese Government Bond market has been through in the last few weeks has some very large and painful consequences, that as yet, have not been discussed widely. The term 'shadow banking' has been one ZH readers are by now extremely familiar with as we have discussed this as the panacea of unseen leverage (most recently in Europe and China) for years; the funding markets in Japan, so heavily reliant on JGB repo for short-term liquidity and the efficient functioning of two-way markets in the bonds, are hitting a wall. As JPMorgan notes, the number of JGB 'fails' - where a repo deal breaks down - has more than doubled in the last week. For a market that represents 40% of the total Japanese money-market, this will be a critical area to watch for a JGB waterfall.

Put down the Sunday newspaper; grab a pot of coffee; and call 'mom' and tell her she has to read this. Doug Rudisch has written a far-reaching summary of the true state of the world and 'why policy has failed'. Simply put, there is no faith in the system; real underlying faith and trust in the system, as opposed to the confidence born from economic steroid injections or entitlements. There also is a subtle but important distinction between faith and trust versus confidence. Faith and trust are longer term and more powerful concepts.There is more going on than a temporary lull in animal spirits that current fiscal and monetary policy will cure. If that was the case, it would be working already... We have ended up with a system where the worst of the risk takers have the ability to take the most risk and are currently taking it at extreme levels. We wish we could be more prescriptive and offer more solutions for the problems. But in order to solve a problem, you must first realize you have one. With respect to the Fed, we don’t think the U.S. realizes it has a problem.