In my previous article on repo, I talked about Wolf Richter's view that a snapback could have made treasury bonds temporarily undesirable. Also, Chairman Powell was quoted where he uttered these soothing words:

...overall financial stability vulnerabilities are moderate.

This Fed doubletalk was meant to soothe. There is only a moderate, not minor, risk of vulnerabilities to financial stability! Not so soothing, if you rephrase it.

It appears that treasuries for use as collateral are only trustworthy if yields stabilize or decline. Counterparties are deathly afraid of yields snapping back up! They would prefer yields to relentlessly decline so the value of their collateral would make margin calls infrequent. So, what are the implications as we approach the zero lower bound and negative rates?

Japan, on the heels of treasury weakness, also had a weak 10 year auction because the government seems weary of propping up the bond markets. And yet it appears that the Fed is just beginning to prop up our bond markets.

So what could have happened causing the snap back?

1. Lack of cash. This is given as the standard reason for the sudden rise in rates. Taxes had to be paid. Accounts had to be settled. But maybe if we read on we can see the lack of cash is more endemic?

2. Too many treasury bonds. This has been put forward as a reason in various articles recently. Derivatives generally create massive demand for treasury bonds, with a relentless downward yield, yet sometimes that demand is weakened. Taper tantrums come to mind.

3. Market manipulation by primary dealers. This is always a possibility since the banks have customers who want yield. We know that some folks believe that treasury auctions have been rigged in the past. Now we find out that banks, with JP Morgan in the lead, have been taking cash out of the money markets. This appears to be an abuse of the counterparties. But you would have to ask a banker. Maybe they deserve it. 

4. Fear of lurking bad collateral like CLOs and collateral put up over the counter with no clearinghouse scrutiny. Fear that almost half of derivatives deals are not through clearinghouses. Fear that derivatives just aren't safe.

5. Keith Weiner's idea of backwardation. Keith has applied the concept to the treasury futures markets. Derivatives are, as we see below, are forcing rates down, and increasing the consumption of capital.

Theory of Backwardation

Well, we know that the primary dealers were not interested in giving up cash in exchange for treasury bonds. Keith Weiner explained this with an interesting theory, that this was the result of treasury bond backwardation. Mr. Weiner clarifies and asks:

A loan secured with a Treasury bill as collateral is as close to risk-free as anything in the financial system (Treasurys are defined as risk-free). And short-term Treasurys are generally treated as equivalent to cash. For these reasons, the spike in the rate is so strange.
One key question is why would a bank need to swap some Treasurys for some dollars, and plan to un-swap them one day later?

He goes on to say:

This means that this week, banks in aggregate abruptly needed cash buffers that are much bigger than they needed last week. It is important to understand that cash is not consumed in a transaction. If one bank pays cash to a counterparty, the cash does not go out of existence. But this week, the parties who had cash were not willing to earn a risk-free profit.

Wait. The market offers a risk-free profit, and no one is taking it? Where have we discussed this before? Oh, yeah. It is when gold backwardation becomes permanent!

The equivalent of gold backwardation has occurred in the repo market. And Barron’s (just to pick on them, other mainstream publications took the same tone) says that there’s nothing to see here, move along folks. 

Apparently the huge amounts of excess reserves are not useful in this collateral situation. Jeffrey P. Snider has all along said they are useless. He says bank balance sheets are what are important, not excess reserves. That means banks are a lot weaker than we think! There are still 1.38 trillion dollars of excess reserves as of August, 2019 but somehow it isn't enough.

Now people are saying that the excess reserves are too little in size. But that makes little sense if we understand that excess reserves cannot be loaned. Not all cash parked at the Fed are excess reserves. Manipulation could be the issue, and one wonders if it was, was it a warning to counterparties going forward? 

In Europe there is MAD, or the Market Abuse Directive, to make it a crime for dominant positions to abuse other counterparties. On the other hand, the Eurozone is hardly an example. It cares nothing about economic growth. Maybe a little uncertainty in the bond markets with collateral issues is a positive thing! .

Derivatives Are Not Safe

Derivatives markets are drivers of contagion.

As growth slows, derivatives become a drag on the economy. Keith Weiner expresses the possible outcome and it isn't pretty:

The root cause of crisis is the consumption of capital, which is enabled and incentivized by the falling interest rate regime. John Maynard Keynes said to drive interest to zero to kill the savers. And he smirked that not one in a million can diagnose what’s happening. That is because the process of driving interest to zero is an endless bull market. The price of an asset is the inverse of the interest rate.

We are siphoning off capital, to consume it in a so-called wealth effect. This is bound to cause crises in the financial system, and threaten the financial intermediaries.

Siphoning off capital takes place as interest rates generally decline, and it is a dangerous game, as Keith Weiner makes quite clear.

Edward Lambert warned about the consumption of capital saying in an email to me:

Effective demand is basically capital income making money off of labor until the point it starts making money off of capital. When capital starts trying to make money off of capital, it is the effective demand limit.

Will these dangers destroy the derivatives markets in the face of a slowing world economy? Will snapbacks become enormous? The intermediaries are the counterparties to the banks, you know, the hedge funds and private capital folks who secure deals through the pledging of collateral--collateral that the banks don't always want, even pristine treasury bonds!

Alexander Saeedly sums it up:

What happened last week was any counter-party in need of cash, and only holding collateral like Treasuries, agreed to pay the much higher going repo rates. That’s supply and demand, plain and simple, and it mirrors what happened in certain repo markets in 2007 before the housing crash and the Great Recession that followed.

 China Won't Help Us the Next Time

China's central bank has reported that it will not expand credit to help the world economy, as was done in the Great Recession. In other words, it is prepared to let Trump and the USA sink or swim on our own. 

Add that to weakness, especially among European banks, with derivatives issues, and we really do need China on our side. There are reports of weakness among French, Spanish, German and Italian banks.

As Canadian Professor Norman Mogul said this about isolationist protectionism and the Fed:

• Protectionist trade policies restrict emerging markets from earning dollars to fund domestic investment; the USD debt levels in these countries are hard to service, given the decline in foreign reserves;
• As Milton Friedman correctly theorized three decades ago, the drop-in liquidity will result in lower, not higher, interest rates as economic activity slows.

The Fed must fight the urge to pursue negative rates, and yet, the bond market seems to demand those lower rates as they look for bond prices to stabilize and increase in value for collateral purposes. That tension cannot go on forever. 

As James Bianco said, the choice is low rates (or even negative rates) or a stock market crash.

It seems obvious, but unproven, that the banks chose to allow a snap back in interest rates as a warning to counterparties, and maybe to the Fed, and to the entire bond market that negative is not a good idea.  

Remember, there was a cap on 10 year bonds at 3 percent. Art Cashin warned not to go much higher. And now, banks could be warning counterparties to not go much lower in yield than 1.6 percent.