No Reason To Toss Out Low Rates In The Inflation Debate: The Repo Rat Rate Fallacy

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A dead rat would’ve easily explained the foul odor, though it wouldn’t have ended the matter. The smell was real, the cause still yet to be identified in the mainstream view. For the bond market, anyway, it was a process of discovery which began with an unexpected stench of something much bigger and more profound than any single or simple rodent (dead or alive).

This was April 2010, an extremely crucial month setting up what would become – over time – several fallacies that have struggled under this weight of contradictory reality. The world was, everyone said, recovering from the Great “Recession” mercifully ended not even a year before due to the combined heroics of central bankers and fitful government spendthrifts (though mostly the former, who took all the press and credit, with their “novel” application of non-standard monetary “accommodation” in the form of QE).

Then that relatively small European nation otherwise imperceptibly nestled into the Mediterranean landscape “somehow” started to derail everything.

On March 4, 2010, the Greek government celebrated market acceptance of its initial “austerity” proposal when its 10-year bond sale went off like gangbusters. The salutations quickly soured as only twenty-five days later a 7-year GGB auction failed to attract nearly as much cheerfulness. Then on April 4, Fitch downgrades Greek credit to BBB- and suddenly…US Treasury yields begin to plummet?

Yes, but several steps remain unidentified, to this day, in between. German and French government bonds had already been trading slightly “special” in European repo prior to April; with the fireworks after the fourth, those began to trade more (steadily) special joined by Belgian bonds (and initially, get this, Italian sovereign!)

What that had signaled was collateral shrinkage and thus extra pressure on bond types which would have been steadily negotiable in repo markets; out with Greek bonds herding everyone formerly using them into the better alternates. If only gross collateral switching and haircutting could be so simple and easy rather than – as the world should’ve realized in September and October 2008 – destructively disruptive.

The fuse had been (re)lit, however, and by the end of April 2010 euro repo was a total mess and well on its way to becoming an unmitigated as well as systemic disaster. Early on in May, well, you can read those details here.

Before everything, meaning global recovery, really began to fall apart, back when Greece was being cheered for its austerity, judging in bonds there was already priced substantial skepticism about that view. Rates should have been moving far more briskly at least back to where they’d begun the Global Financial Crisis (why and how was it global, again?) but remained instead stubbornly and noticeably less than their pre-crisis launch point.

The global recovery was proceeding, but there was this nagging worry over how it wasn’t really a recovery. Too many questions were left, too many unsolved “riddles” like Greece and its effects on global repo. Despite Ben Bernanke’s most illustrious efforts, as early as March 2010 some instead had smelled a rat.

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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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