TFTB – The Fed Needs You To Sell Your Bonds

In yesterday’s “Thoughts From The Beach (TFTB),” I discussed the issue that the Federal Reserve may be anticipating a surge in inflationary pressures that may not present as of yet. The problem, as was seen in both in 1999 and 2007, is that when the Federal Reserve begins to raise interest rates, particularly in a low volatility and perceived “no risk” environment, bad things tend to happen.

This is an issue that simply cannot be lost on the Federal Reserve. However, if that is the case then the question becomes what is potentially concerning the Fed enough that they are willing to risk sparking a market reversion? Barclay’s Joe Abate provided a possible answer.

“Delivery fails in the Treasury market have surged recently. On Monday, the DTCC reported that incomplete deliveries reached a 52-week high at $120bn. And a week earlier, Treasury fails – as measured by the Federal Reserve – exceeded 6% of daily dealer Treasury transactions volumes.

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 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.

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.

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.

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.”