Since the beginning of July, there’s less “noise” in the General Collateral (GC) market, with less volatility in Treasury issuance and the April collateral shortage is now far in the past. Given that GC is still firmly trading close to 0.0%, it means the near zero percent rates are clearly a result of the QE3 and QE4 purchases. It took approximately 6 months of Fed QE purchases to move GC rates from an average of .24% in December 2012, down to an average of .05% this month. Therefore, there is a growing distortion in the short-term funding markets which is clearly one of the first unintended consequences of the QE programs to surface.
If the Fed continues QE buying for another 6 months at the current pace, can GC drop another 19 basis points? No, we’re just 5 basis points away from 0.0% right now. There’s little chance that GC rates will remain between .02% and .05% if the Fed continues to take securities out of the market, so it’s logical to assume GC will drop to 0.0% each day, like a heart monitor flat-lining on a dying patient. Even if the Fed pulls-back purchases and “tapers” later this year, it just means they’re purchasing less, and thus they continue to remove collateral from the market, albeit at a slower pace.
There’s the potential that the QE purchases will create a major distortion in the Repo market, and at some point, something’s got to give. Market pressure to move below 0.0% will cause distortions in the Repo market. Though we could discuss some of the potential market distortions from GC at 0.0%, I believe it’s uncharted territory and there’s a significant risk building up in the funding markets.
How To Stop The QE Repo Market Distortion
The Fed can prevent the unintended consequences of the QE3 and QE4 programs in a number of ways:
- End the QE programs.
- Wait for another Debt Ceiling Crisis or major bond market sell-off to dump Treasury collateral back into the market. And as it turns out, the government could hit the Debt Ceiling again in November, or at least by the end of the year, so in one way, we have that to look forward to.
- The Fed could begin to execute “repo operations” with the Street. Formally called “Matched-Sales,” the Fed can intervene in the Repo market and put collateral back into the market. With GC rates close to 0.0% and having traded intra-day at negative rates many times over the past few months, I’m surprised the Fed has not executed any Repo operations to date. However, putting Treasury collateral back into the market after having removed it for QE could create market confusion. Perhaps traders might think it’s a tightening move – or even a signal of less easing? Perhaps the Fed embarrassed to inject Treasurys back into market after having removed them for QE, it might signal that there’s a flaw in QE policy.
Surge In Fails
There is speculation flying around the market about the sudden increase in Treasury fails in June. The large increase in fails in June, not only corresponded with Bernanke’s “tapering” speech at the end of May but also the massive sell-off in the bond market. However, those events happen to be coincidences, because the increase in fails is 90% related to the 10 year note.
As I’ve discussed in the past, the Repo rate for the US Treasury 10 year note is at the mercy of the 10 year note’s auction cycle. Initially, this 10 year note was issued and settled on May 15, with scheduled reopenings (new supply) on June 15 and July 15. In other words, from May 15 until June 15, the 10 year note was a single issue and between June 15 and July 15 a double issue. After supply from the second reopening settled on July 15, it became a triple issue – you may have noticed the fails went away and 10 year note Repo rates are close to 0.0% again.
Fails – The Layman’s Analogy
I saw questions about securities fails on blogs this past week, the explanations were mostly right, but I thought a good analogy was in order:
Suppose someone wanted to buy a book on Amazon, so let’s just pick a book at random, like “The Money Noose – Jon Corzine and the Collapse of MF Global” by an up-and-coming new financial author. The individual clicks on the book and Amazon puts the book in the “shopping cart.” The individual then goes to the online “checkout” to pay for it. Let’s say the book buyer decides they want Standard Shipping (“Reg” shipping) of 3 to 5 business days – that’s the equivalent of the “settlement date” in the securities markets. The book appears to be “in stock,” so no delivery problems are expected with the order. Once the buyer inputs their credit card information, they just agreed to exchange their money for the book – kind of like a delivery-versus-payment (DVP), but not at the exact same time. Think of the book like a security and the credit card is the payment for the securities. When the person clicks on “Place Your Order,” the trade is done, and the current day is the “trade date” – the date in which both parties, one a book seller and one a book buyer, agree to the transaction.
As it turns out, “The Money Noose” has become a very popular book and there are a lot of people trying to buy it. As a consequence, Amazon runs out of inventory and has to order more. After 5 business days, the book buyer finds they have still not received the book. Unbeknownst to the book buyer, Amazon is in the process of waiting for more books to be delivered from the publisher. The publisher is waiting for more books to be delivered from the printer. As a consequence, Amazon is “failing-to-deliver” to the book buyer.
The book buyer is unhappy with their “fail-to-receive,” since the book was listed as “in stock”, but of course, Amazon did not know there would be such great demand for “The Money Noose.” Perhaps it was an unforeseen event like the Civil Complaint filed by the CFTC against Jon Corzine which caused the surge in demand. Luckily in the book world, just like in the securities world, Amazon is able to go to the publisher and order more supply to “clean up the fails,” just like the Federal Reserve reopens the 10 year note to clean up its fails. Eventually, the market will have all the supply of the 10 year note it needs and book buyers will have all the supply of “The Money Noose” they need!
The European Financial Transaction Tax (FTT) combined with Dodd-Frank Section 165 should make it clear that both the European and US governments don’t want European banks in the Repo financing business. For a European bank operating in the US, it could be “lights out” for Repo matched-books by the middle of next year.
Here’s an update on the FTT, which I like to call the “European Repo market destruction tax.” First the good news: the European Commission failed to persuade all 27 EU member countries to implement the tax. Now the bad news: 11 EU member countries, led by Germany and France, have agreed to continue with the tax. If all goes well, the new 11 member tax will launch around the middle of 2014, a six month delay from the original launch date of January 1, 2014.
The more, let’s say, level-headed European nations have serious concerns about the tax. Strangely, though they’re worried about the tax’s impact on their ability to issue their own debt, they express little concern for companies within their borders facing the same obstacles. Additionally, there are questions about how to split up the tax revenue, in other words, everyone wants their piece of the kill. There are some good concerns about the effects on small and midsize companies and some nations are worried about how it will affect market-makers – the same debate we’re having in the US about the Volcker Rule: how to separate pure speculation from the useful market-making and liquidity providing banking activities.
Dodd-Frank Section 165
Dodd-Frank Section 165 is the part of the law that applies to foreign bank subsidiaries in the US and specifies that capital held at the parent bank level cannot be assumed to support a US subsidiary. In practice, it means that 26 foreign banks will need to establish Intermediate Holding Companies (IHC), and hold more capital to support their US bank and broker-dealer. Given that foreign banks account for 25% US banking activity, it will make banking more expensive for foreign banks in the US and affect the US markets. An Oliver Wyman study estimated the IHCs will create a $330 billion reduction in the Repo market, equal to about 10% of the entire Repo market. In reality, I expect further changes in the Repo market to eliminate the “middleman.” Smaller US banks, US broker-dealers, hedge funds, and money market funds, which are “customer” financial institutions, will emigrate to a system of end-buyer to end-seller Repo trading, using fewer foreign banks as intermediaries.