It’s A Rate Train Coming Your Way

On December 26, 2018, the US Treasury sold off $41 billion in 5-year notes. “Only” $85.8 billion in bids were submitted, weakening the widely watched bid-to-cover ratio to a chatty 2.09. The prior sale of 5s had yielded a bid-to-cover of 2.495, nearly $100 billion in bids for $40 billion on offer, so something was clearly up.

Had it been finally “too many” Treasuries as had been claimed all year to that point? Or had traders taken their sweet time returning to dealer warehouse duty following the Christmas holiday off?

No, it had been a (clear) sign of the times meaning a signal at the time no one wanted to receive or appreciate. Remember, Jay Powell the hawk was homing in on accelerated inflation demanding what he forecast would be an enhanced rate hike timetable from the Fed. Things were, he claimed only weeks beforehand, proceeding according to that schedule.

Yet, by then, especially Christmas Eve 2018 trading, it was as if safe and liquid instruments were scarcely available in the secondary market. Treasury prices had reversed under serious and sustained demand. The global marketplace was uniform in declaring renewed fears driving the need for more safety and higher liquidity preferences; renewed deflation rather than a paradigm change toward inflation.

When we think about how the system actually works, the “bad” auction of December 26, 2018, actually makes a lot of sense even in the context of very strong secondary demand. What is it that creates this global illiquidity anyway, the substance of these occasional global dollar shortages?

Lack of money dealing, the constraints on dealers’ balance sheets which can manifest in seemingly odd ways.

As this “landmine” of a reversal reached its short run crescendo late in ’18 and in the first few days of ‘19, the two things happened simultaneously while appearing to be in opposition but in actuality consistent: the secondary market wanted Treasuries, as many as possible, while at the same time dealers were prevented from getting all they might have representing the substance of illiquidity driving the demand for safety in the first place.

Since that late December 2018 auction, 5-year note sales haven’t seen close to that few relative bids again. The lowest bid-to-cover was, incidentally, for a relatively recent $62 billion operation conducted on…February 24 of this year.

Yes, that February 24.

As I’ve pointed out, everyone remembers the 7-year auction on the 25th for how much it resembled the bid-to-cover problems of the 5-year auction back from December 2018. As I’ve also documented, two days before this, on the 23rd, Treasury had been able to auction off 2-year notes without so much as a hint of irregularity.

That had left just the specific 7-year auction on the 25th to stand out alone…well, almost by itself.

While it wasn’t nearly the same kind of outlier, the 5-year sale on February 24 featured the outlines of what would become of the 7-year the next day. A slightly but noticeably lower bid-to-cover as dealers were kind of missing at the margins, but nothing like the deficiency had been in December 2018.

This suggested that what was going to follow on the 25th in the 7s, and the huge Treasury market selloff it sparked, had begun to some detectable extent on the 24th in the 5s. Interestingly enough, the cutoff for competitive bids for this particular 5-year sale was the usual 1 pm ET.

According to what little we know from authorities, the Fedwire disruption was first noticed at 11:15 am ET – just as dealers were finalizing their bids, books, and diagnosing their own liquidity parameters for the rest of that day and almost certainly the potential bottleneck spilling over into the next. And yes, Fedwire most often does link final settlement in the primary Treasury market.

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Disclosure: This material has been distributed for informational purposes only. It is the opinion of the author and should not be considered as investment advice or a recommendation of any ...

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