Following Surge In "Fails To Deliver" To Two Year Highs, Treasury Market Finds A Brief Respite

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.

In the grand scheme of things, however, the recent move is tiny by complete market lock up measures: one need only recall that during the height of the Lehman failure crisis, virtually the entire $3 trillion repo market had locked up and not a single Treasury was being delivered or received in repo (this is somewhat apples to oranges as the Fed revised its methodology of tracking primary dealer data at the end of March).

But perhaps the best indicator of just how bad the Treasury market had gotten until the settlement of last week's 10 Year reopening, is the repo rate, which had plunged deep inside special territory in the first week of June and was consistently at the penalty rate of -3% (established in 2009), and slightly special for far longer. This means that those seeking to borrow 10 Year paper have had to pay up to 3% on an annualized basis: hardly a sustainable IRR in the ZIRP new normal.

This was also reflected in the General Collateral rate which recently dropped to as low as 0.04% or the lowest since July 2011, and which popped back to double digit territory, or 0.11% according to ICAP, as of this morning.

That said, don't expect the renormalization in 10 Year repo rates to last: if anything, last week's auction showed just how thin the liquidity and collateral availability in shadow banking really is: if just a $7.7 billion allottment to Primary Dealers (as per the 10 Year reopening) can send the repo rate from -3% to positive, then the action on the margin is truly unprecedented.

This is accentuated by both the Fed's ongoing monetizations in the 10 Year space which actively withdraws securities from the private market, as well as the aggressive shorting of 10 Year paper, both as an outright bet on interest rates, and as a need to hedge rate risk in pair trades with corporate bond purchases.

Keep an eye on the repo market: with such pronounced collateral shortages, and with the Fed repeatedly expressing its concerns with the shadow banking system, Bernanke may be ignoring all signs of bubbles in the traditional markets, but he has no choice but to take the signals sent by the shadow market seriously. And if he indeed does not taper, this means that even more eligible OTR collateral will be withdrawn from the market, repo rates will continues to be punitive, and sooner or later this will have a substantial impact on downstream liquidity channels, first at the Primary Dealer community, and then everywhere else.

Source: NY Fed