EUROMONEY: US treasury market reaches breaking point

[Sapiens]

http://www.euromoney.com/Print.aspx?ArticleID=2054070

Tuesday, November 25, 2008
US treasury market reaches breaking point
by Helen Avery

As attention focuses on the treasury market's ability to cope with the US's growing funding needs, Euromoney reveals the structural issue that could cause the world's market of last resort to grind to a halt in its hour of greatest need.

The problem: the settlement system for the US government bond market has broken down

THE US TREASURY market, the foundation of government bond and corporate bond markets worldwide, is suffering a crisis of confidence at the worst possible moment. Investors in treasuries are the lenders enabling the US government bail-out of the country’s broken financial institutions. That leaves them financing purchases of equity of volatile and highly questionable worth and backing a ragbag of distressed assets. For now, treasury yields are at record lows across the term structure as investors with cash to invest conclude that they can trust no one else with their money. But investors must wonder at what point the expanded supply of government debt and its use will make the borrower inherently less creditworthy.

There is an even more pressing concern for many participants in this increasingly swollen market: the settlement system has broken down. Following the collapse of Lehman Brothers in September, fails to deliver among the 17 primary dealers in the US treasury market have rocketed to more than $2 trillion over a period of weeks and still lie above $1.3 trillion. Broker/dealers have stopped delivering bonds. Holders of US treasuries are now scared to lend into the repo market in case their bonds are not returned, and potential buyers sit on the sidelines fearful of handing over their money to a counterparty that at best might not deliver a bond on time, and at worst might go under.

With global stock markets plummeting, investors are still turning to treasuries as a safe haven. But investors might become nervous if something is not done soon to sort out the market’s problems. “As yet investors are still coming in, but in the longer term the worry is the lack of functionality in the treasury market. That could impact investor perception on a longer-term basis,” says Mike Pond, US treasury and inflation-linked strategist at Barclays Capital in New York. If investors turn their back on treasuries, the US government will find it increasingly difficult and expensive to raise money and roll over its maturing debts. Upward pressure on interest rates will occur at a time when the government needs to be loosening monetary policy in order to jump-start a domestic economy that is heading towards a depression.

As a result of fails to deliver, the most transparently priced instrument available now has investors scratching their heads. The natural balance of supply and demand has been altered and the true price of treasuries has become obscured. The effects are being seen across other bond markets. “The TIPS (Treasury Inflation Protected Securities) market is also clearly broken,” says Pond. “An obvious trade right now would be to go long TIPS where real yields are high and short the nominal bond in a breakeven inflation trade but hedge funds are fearful that if they go through the repo market the borrow could fail. So we have a situation now in the 10-year TIPS where the market is pricing in zero or negative average inflation for the next 10 years. Inflation has not been that low since the 1930s.” Economists also claim that fails have spread across to other bond markets such as municipals, agencies, mortgage-backed and corporate bonds.

Why the Federal Reserve is not urgently considering regulation is bewildering. As yet, the US Treasury has merely asked for market participants to sort out the situation themselves. That might help reduce fails but it will not eliminate them, and in panic periods they will simply creep back up. The global economy has significantly contracted since the collapse of Lehman Brothers, which spurred the fails to deliver. More market-shocking events are certain to lie ahead. The solution is simple – delivery needs to be enforced, and liquidity returned. If not, confidence in the US treasury markets will be lost. Loans made using treasuries as collateral will be reconsidered, bond markets priced off treasuries will further dry up and, with equity markets so volatile, central banks and investors will not know where to turn.

Fails to deliver in the treasury markets are not a new phenomenon. There is data for fails for treasuries, agencies and mortgage-backed securities as far back as 1990, says Susanne Trimbath, an economist, and former employee of the Depository Trust Co, a subsidiary of Depository Trust and Clearing Corp.

Back then, though, there would be $50 billion of fails in a whole year, she says. That figure has grown enormously. Failures in US treasuries were 8.6% of all treasuries outstanding in the first five months of this year, compared with 1.2% in the first five months of 2007. That has ballooned further over the past three months, hitting more than $2 trillion for almost the entire month of October – more than 20% of the daily treasuries trading volume.

What the treasuries market faces now, at this critical moment, is the consequence of long neglect of some murky aspects of short-term tactical trading in government bonds.

[Master Shake]

Re: EUROMONEY: US treasury market reaches breaking point

“The TIPS (Treasury Inflation Protected Securities) market is also clearly broken,” says Pond. “An obvious trade right now would be to go long TIPS where real yields are high and short the nominal bond in a breakeven inflation trade but hedge funds are fearful that if they go through the repo market the borrow could fail. So we have a situation now in the 10-year TIPS where the market is pricing in zero or negative average inflation for the next 10 years. Inflation has not been that low since the 1930s.”

So, that would make TIPS a screaming buy, right?

[oddlots]

Re: EUROMONEY: US treasury market reaches breaking point

I've seen this discussed at Jesse's Cafe but I'm still waiting for the penny to drop, despite his (her? - I always assumed Yves Smith was a man so better play it safe) quite clear explanation via the Fed:

http://jessescrossroadscafe.blogspot...ive-fails.html

In my usual punching above my weight fashion let me try and think through what this might mean:

- I don't really get the upshot of the article as it seems to suggest that bonds are being hoarded and not being re-cycled through the repo markets. In other words they are so valuable - perceived to be without counterparty risk - that they will not be loaned out. The evidence is that institutions would rather risk a failed trade than participate in a pass the parcel exercise where the collateral never returns back to them. It seems perverse that in the article the distrust between institutions is somehow being taken as evidence of an impending crash in the value of the very thing they are clinging to to protect themselves from each other.

- Or is it simply that, with fails this high, no-one knows who even owns any bonds anymore? In other words, you might stop buying bonds because you don't know whether the particular dealer was in a position to sell you any once all these counterparty transactions are netted out.

- I've seen the notions of bonds being monetised (i take that to mean used as collateral to fund / leverage) purchases of other assets referrred to at itulip and other sights. Is one significance of this that this function of the bond market ceases to work if - through extreme distrust of dodgy balance sheets of counterparties - banks are unwilling to recycle treasuries in this way?



Could someone help with this?

[ASH]

Re: EUROMONEY: US treasury market reaches breaking point

- I've seen the notions of bonds being monetised (i take that to mean used as collateral to fund / leverage) purchases of other assets referrred to at itulip and other sights. Is one significance of this that this function of the bond market ceases to work if - through extreme distrust of dodgy balance sheets of counterparties - banks are unwilling to recycle treasuries in this way?

Regarding monetization of bonds, I believe this refers to a central bank buying bonds and creating reserves to pay for them. This is one of the ways in which money is created... when expanding the money supply, the Fed's normal open market operations involve buying existing government bonds from banks, and crediting the banks with newly-created reserves as payment. However, when the word "monetization" is invoked, it often refers to the particular case in which the central bank buys new bonds issued by its corresponding government directly, as opposed to buying them on the open market. The distinction between buying directly from the government versus from the open market is that there is then no limit to the amount of debt that the government can issue in exchange for money from the central bank, since it is normally the market that limits demand for and creation of government debt. This is the most rapid way that a government can destroy its credibility and its national currency, because it can pay its bills with newly-created money. If large-scale monetization of the US debt was deemed likely by the market, I would expect bonds -- and dollars in general -- to be dumped rather than hoarded. In my opinion, if the market thinks monetization will be limited to the creation of money sufficient to back-fill the expanding credit hole, or that monetization will be synchronized across the major currencies, then the market's reaction will likely be more muted.

I think you are correct that the recently-announced $500 billion purchase of agency mortgage-backed securities constitutes monetization of those bonds. As The Economist puts it:

The MBS purchases are significant; for the first time they turn the Fed into a direct lender to consumers. Many homeowners, though they do not know it, will be sending their monthly mortgage payments to the Fed. The Fed will finance these programmes with newly created reserves: that is, it will print money. Its balance-sheet, which has ballooned from $900 billion to $2.2 trillion since August, could grow by another $800 billion, making it a larger lender than any commercial bank.

That said, the purchase of MBS and other bailout-related activities may be perceived as a special case. The collapse of the credit bubble has resulted in deflation of assets such as MBS, which in turn creates holes in balance sheets and massive losses; the paper that had notional value two years ago is next to worthless today. The Fed is monetizing this paper, creating money to replace that lost value -- the worthless paper is now worth something because the Fed will create money to buy it. I haven't thought about this enough, but my immediate impression is that to the extent that the collapse of the notional value of this paper is deflationary, the monetization of that paper is not inflationary relative to the conditions that existed before the credit bubble collapsed. Yes, money is being created out of thin air, but it is filling in a hole. (One complication that occurs to me is that Federal Reserve deposits are more powerful than the paper they replaced. Hopefully other posters will point out the things I have not thought of.)

On the face of things, the announcement that the Fed is creating hundreds of billions of dollars from thin air to finance the bailout would be very dollar-negative. However, I haven't seen any immediate reaction to this news, so I have been looking for an explanation, and the best I can come up with is what I've outlined above. My best guess is that if we were paying down pre-existing debts, or paying for new spending, by massive creation of new dollars -- with a large and measureable increase in the money supply -- then we would trigger a run on the dollar. But somehow, the market seems to tolerate the large-scale monetization of assets whose value has collapsed. The rationale seems to be that so long as you're filling in holes, you maybe aren't increasing the money supply, and therefore you aren't undermining the purchasing power of the dollar.

Anyone else have a guess?

[Southernguy]

Re: EUROMONEY: US treasury market reaches breaking point

This thread is basically to technical for me. I´ve been watching closely for last weeks 30 year treasuries prices.
Thinking they were too high, based on clear baseline facts, I´ve bought some TBT.
Fortunately not too much of it. It´s more or less 30% down since.
Two questions arise: 1) Will they go up much further. 2) Is TBT a safe bet, not regarding prices, but underlying counterparty risk?
To the first question I don´t expect anyone to have a secure answer...;).
But to the second one I would really thank someone more wise and informed to tell me.
The graph of 30 YT´s yield is astounding. The one I´ve found goes from 1978. Today value, at 3.23% is by far the lowest. And this is happening when all economic conditions, US debt, US fallling economy, money origination, etc would suggest the opposite to be.

[Chris]

Re: EUROMONEY: US treasury market reaches breaking point

Have a look at the T-bond futures market (March 09 Contract). Something big happened today. Anyone know what the FED has been up to?

[Mega]

Re: EUROMONEY: US treasury market reaches breaking point

I think THEY (as in the Fed) started buying T Bonds????
Mike

[metalman]

Re: EUROMONEY: US treasury market reaches breaking point

Have a look at the T-bond futures market (March 09 Contract). Something big happened today. Anyone know what the FED has been up to?

this was it, i think...

Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve's quiver--the provision of liquidity--remains effective. Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand. Indeed, last week the Fed announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. It is encouraging that the announcement of that action was met by a fall in mortgage interest rates.

http://www.federalreserve.gov/newsev...e20081201a.htm

[GRG55]

Re: EUROMONEY: US treasury market reaches breaking point

I've seen this discussed at Jesse's Cafe but I'm still waiting for the penny to drop, despite his (her? - I always assumed Yves Smith was a man so better play it safe)...

Good thing you covered your bet ;). Your assumption is incorrect. Yves Smith is female.

Her blog is called Naked Capitalism.

[ASH]

Re: EUROMONEY: US treasury market reaches breaking point

this was it, i think...

Now, just so long as they keep purchasing on the open market and not directly from the government...

Still, I can imagine how this could get out of hand. If the policy has the desired consequence of spurring demand for the longer-term bonds, then that means demand from the Fed is feeding through into the broader market. Pretty soon there might not be such a nice distinction between the Treasury selling to the open market and the Treasury selling to the Fed directly.

I've already posted my musings about why this might be less dangerous than it feels... but it does feel like they are playing with fire.

[charliebrown]

Re: EUROMONEY: US treasury market reaches breaking point

I don't fully understand the implications of this. As I am an electrical engineer by trade who had one macro econ course 25 years ago.

OK if fed start buying t-bonds, then the fed is taking on much more interest rate risk?? If the rates on t-bonds go up, their value falls. ergo the fed takes it in the balance sheet.

This is where I'm a bit fuzzy. The fed is M0 correct? and M1 ... M3 are
basically multipliers of the fed's balance sheet as it is leveraged out by member banks. So if M0 contracts so does M1 et. al. and exponentially so?

What could cause t-bonds yields to rise? What if the recession is much worse than currently thought, the treasury finds itself needing more and more money for bail outs and the tax receipts are falling at the same time??

Will people keep on lending money to a entity with rising debts and falling income? Will this unwind gradually with the fed selling t-bonds into the
market over time, or will it go non-linear? with a run on the dollar?

Do I just back up the truck now and start buying gold @ 750??

[bart]

Re: EUROMONEY: US treasury market reaches breaking point

Now, just so long as they keep purchasing on the open market and not directly from the government...

In my opinion, there is a hole I see now that you've expanded your thought and I get it better.

If the Fed buys a GSE or other instrument at more than its actual value, that portion above real value is monetization.
Or if the Fed buys a GSE or other instrument from a bank that has basically been nationalized, that's monetization.

When the Fed loans directly into the system, fractional reserve principles apply... and that's basically monetization. The Fed is almost a hedge fund now too, in the sense that its balance sheet is leveraged at 40 or 50:1.

[The Outback Oracle]

Re: EUROMONEY: US treasury market reaches breaking point

Like ASH I struggle with this stuff. However, my education in Economics, be it a long long time ago, inculcated in my wee brain the fact that, for a successful economy, you had to get a whole lot of things balanced. A balanced household economy will have expenditure and savings such that it provides capital to industry to expand and innovate, as well as paying sufficient taxes to the government to allow it to function. The Government will balance it's expenditures, at least over a few years, such that it does not run massive deficits. If these sectors were balanced, then the external sector would also be balanced, and we would not be selling our industries off to foreign Governments and companies, just to pay for our luxury consumption.
Most Western economies are so out of whack one form, and another that it comes as no surprise to pretty well everyone here, that the whole corrupted system has come apart. Bear in mind that, up till 18 months ago, very few people, outside this type of forum, saw anything in anyway wrong or at risk.
In the case of the US, it seems there is not a single sector of your economy that has been balanced in any way. Every sector, household and industry, Government(at all levels), and the external account, is operating on massive debts. Other nations tend to have at least two sectors out of whack.

So, my thoughts are similar to ASH's in that everyone thinks the FED is just 'filling in holes' in the, what should be, a smooth road to riches for us all. In that case, as per ASH's conjecture, I would agree everyone thinks there is no damage.
HOW BLOODY EVER..........(now sorry ASH...you are so eloquent and concise,and my language deteriorates as I warm up :mad::mad::mad these stupid stupid morons still cannot see that the whole bloody thing is totally out of whack! They still cannot see that all the problems are caused by excess credit creation, They cannot see that there is actually something even mildly awry in running a CAD of 6% of GDP! They cannot see that there is a problem when the whole industrial complex of a country is shut down. They cannot see that there is a problem when we are all spending our way into oblivion, and the security we are supposed to be guaranteeing our people is being shattered by the day. They cannot see anything wrong when people are losing their jobs, and the only jobs that become available are no-skill low pay casual for a few hours a week serving coffee and donuts. They cannot see anything wrong with mortgaging the souls of our children in order to indulge ourselves now.
So, ASH yes, everyone has a benign outlook to the FED monetization on the basis you outline. However, they do so because they cannot see that it is perpetuating all the problems that brought us to this 'pretty pass' and people regard that as, not only normal, but able to be continued in perpetuity. It is the 'equilibrium' that modern economic theory presumes will automatically re-establish itself when this is 'over'.
There seems to have been a great 50 year period in Business and Economics education, that, in the area of the brain where things, such as the consequences of debt (either external or internal), are stored and measured, has just left a massive vacuum. Therefore the distorted view of reality may continue for some time yet.
The price of such policies is high, but may be met after Bernanke has retired back to Princeton.
Exactly the same as the problems caused by Greenspan did not erupt until he retired to the Lecture Circuit.

Now as to when the illusions might be shattered, and this becomes an actionable distortion, I've no idea. Given that these clowns have no idea how we got here, the odds of them getting it 'just right' have got to be pretty slim.

[ASH]

Re: EUROMONEY: US treasury market reaches breaking point

OK if fed start buying t-bonds, then the fed is taking on much more interest rate risk?? If the rates on t-bonds go up, their value falls. ergo the fed takes it in the balance sheet.

I think you may be putting the cart before the horse. It would be better to think of the Fed as an organ of government policy, as opposed to a commercial bond-trading entity... the technically private status of the Fed notwithstanding.

[kartius919]

Re: EUROMONEY: US treasury market reaches breaking point

Its called DEBT DEFLATION. The world was super charged with credit resulting in massive appreciation in all world assets. Now that credit has poofed and what was propped up by the stupid ponzi scheme is falling like a rock. Central Banks can't print the 50 trillion or so of credit that is lost. Banks are insolvent so no way they are lending. Look for massive losses in commercial real estate next year as consumers stop shopping and strip malls become ghost towns. Quantitive easing can't do sqaut now until they pump trillions into the hand of consumers to pay off the debt and reflate the economy. Everyone should read A Bubble that Broke the World by Garrett, bloody brilliant. Massive deflation followed by massive inflation, god help us all.