Authored by Paul Mylchreest's Thunder Road Report from Monument Securities,
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.
In the last report, we analysed the negative consequences of QE on the (oh so vital) liquidity of the shadow banking system. In particular, the way in which QE disrupts the flow of “high quality collateral” by “silo-ing” Treasury and MBS securities.
The IMF, Bank for International Settlements, Bank of England and US Treasury Borrowing Advisory Committee (TBAC) have published reports in recent months warning of the risks.
The TBAC identified the gross shortage of high quality collateral – US$4.6-11.2 trillion - under “stressed market conditions”.
It’s abundantly clear that this is where (massive) systemic risk lies... we can only hope that we don’t return to “stressed market conditions” for as long as possible. The Federal Reserve is acutely aware of these risks – as we’ll demonstrate - but (no surprise) doesn’t identify them specifically. The closest we got is probably the speech on 28 June 2013 by Fed governor, Jeremy Stein, who commented (my emphasis):
“Although asset purchases also bring with them various costs and risks - and I have been particularly concerned about risks relating to financial stability - thus far I would judge that they have passed the cost-benefit test.”
Most people have failed to notice, but recent developments have cast light on the collateral issue.
Under the provisions of the Dodd-Frank Act, many OTC derivatives are migrating to exchanges in three stages during 2013. This is leading to increased volumes of collateral needing to be lodged with central counterparties (CCPs).
The first stage was implemented on 11 March 2013, the second on 10 June 2013, with the third due on 9 September 2013. A clear signal of stress in the shadow banking system is a surge in “fails-to-deliver”, which reflects a shortage in the availability of high quality collateral. The first two stages of the migration to CCPs, in March and June, resulted in spikes in fails in US Treasury repos.
In March, the collateral shortage was particularly severe in the benchmark 10-year Treasury which traded at the “special” 3% penalty rate in the repo market. This was Zero Hedge’s Tyler Durden on 15 March 2013:
“If the ongoing repo super-specialness persists, beware: as it will be the first time since Lehman that cracks have appeared in the very fragile shadow banking system...the critical nexus that allows Dealers to transform reserves into risk-asset purchasing dry powder.”
the same thing happened in June - this from Bloomberg on 4 June 2013...
“A shortage of U.S. Treasury 10-year notes in the government debt funding market has traders willing to pay to borrow the securities in exchange for loaning cash for the most actively traded maturity. The overnight repurchase agreement, or repo rate, for the 1.75 percent note due in May 2023 opened at negative 2.95 percent and closed at negative 3 percent at 10 a.m. New York time”
In a recent post on the Alhambra Investment Partners’ website, Jeff Snider observed a change in the patterns of Fed purchases of Treasuries in its QE programme. Noting that repo counterparties prefer the most recently auctioned (i.e. on the run or “OTR”) Treasuries, he pointed out that the Fed had bought 25% of the OTR 5-year issue in January 2013, 13% of the next issue, then under 5% and zero of the last issue. In the 10-year, the Fed bought 18% of the January 2013 issue, then 8% followed by zero.
“What the SOMA (System Open Market Account) data above suggests, and highly so, is that the Fed recognizes the role of QE in removing OTR collateral. Why else would they start by purchasing relatively high proportions of OTR’s and then drop to nothing, or nearly nothing, after the repo markets went so special? It seems pretty clear to me that the Fed noticed the repo warnings and acted, thus confirming, operationally, what we have suspected about QE...
Bottom line is I believe collateralized lending markets, the marginal source of effective liquidity post-2007, are short of collateral for numerous reasons, leading to all manner of side-effects.”
On 17 July 2013, the SEC took a more active role in the repo market when it asked money market funds to review procedures should there be defaults in the repo market. According to Reuters:
“The U.S. Securities and Exchange Commission on July 17 quietly issued new guidance to money funds that spells out the risks they could face if borrowers in the tri-party repurchase market collapse...
In a four-page document, the SEC urges funds and advisers to review master repurchase agreement documentation to see if there are any procedures to handle defaults, and if necessary, prepare draft templates in advance. It also calls for funds to consider the operational aspects of managing a repo, and to contemplate whether there are any legal issues that could arise in the event of a repo default.”
The phrase “Watch this space” is not going to lose relevance for an “extended period” when it comes to collateral and shadow banking.
Another market which is a focal point of the ongoing crisis is gold.
We highlighted last time how gold had moved into backwardation in the futures market, i.e. near month future lower than spot, in April 2013. This remains the case and as Sandeep Jaitly commented in his July 2013 Gold Basis Service:
“Not only has the backwardation remained in gold, but it has escalated”
The backwardation in gold effectively spread from the futures market to the lending market in London when GOFO (Gold Forward Offered Rate) went negative on 8 July 2013.
GOFO is the interest rate to borrow dollars using gold as collateral. If you are a gold holder, a negative GOFO means that the market is prepared to lend you dollars AND pay interest in return for use of your gold for the duration of the loan. As with backwardation in futures, it implies that there is stress in the system with regard to the availability of physical gold – in this case 400oz. London Good Delivery bars on the LBMA.
This is only the fourth occasion since 1999 when GOFO has been negative. On the other three occasions, the negative rates lasted two days and coincided closely with lows in the gold price (1999, 2001 and 2008). We’ve been shouting from the rooftops since 2006-7 that the gold market is a gigantic fractional reserve system consisting of a vast quantity of paper claims to gold bullion and a much smaller inventory of actual bullion.
Thanks to Ned Naylor-Leyland of Cheviot Asset Management for pointing me in the direction of the Reserve Bank of India’s January 2013 report “Report of the Working Group to Study the Issues Related to Gold Imports and Gold Loans by NBFCs.”
On page 58 is the following data sourced from the CPM Gold Yearbook 2011:
In the words of the RBI with my emphasis:
“the traded amount of ‘paper linked to gold’ exceeds by far the actual supply of physical gold: the volume on the London Bullion Market Association (LBMA) OTC market and the major Futures and Options Exchanges was OVER 92 TIMES that of the underlying Physical Market.”
The CFTC’s Bank Participation Report on trader positions on COMEX for June 2013 showed that the US bullion banks had moved to a net long position of nearly 30,000 contracts (3 million oz.) from a huge net short position of 106,000 contracts (10.6 million oz.) when gold peaked in October 2012 – an overall swing of about $20 billion in fiat terms – into a declining market.
The July 2013 data shows that the US bullion banks increased their net long position to almost 45,000 contracts, while speculators (hedge funds?) increased shorts and reduced longs.
Are the banks (finally) getting ready to squeeze the funds, or are they preparing for another big raid? We hope the latter given that the apparent depletion of gold inventory in the vaults continues. Below is the data for COMEX registered vaults.
Furthermore, Rabobank has followed in the footsteps of ABN Amro in suspending delivery of physical bullion to its clients. With rumours circulating that a major bullion bank is preparing to change its delivery agreements, the implication being that it too will suspend or curtail physical delivery, we are wondering whether the breakdown in the physical versus paper gold markets is approaching...leading to price discovery for physical gold itself.
Full Thunder Road report below (covering the Emerging Market Slowdown and the Central Bank manufactured recovery)...