What happened? The Dow Jones Industrial Average dropped from 17,200 at the end of September to a low of 15,900 last week. The Treasury 10-Year note rallied from 2.50% on September 29 to 2.15% on October 15. It was an incredible rally for the 10-Year note in just one day. At one point, it even hit an intraday low of 1.87%. Call it a correction, but there was definitely some sort of panic involved. Some say it was related to Ebola, slow growth, or even another round of QE. Overall, it was very reminiscent of a flight-to-quality (FTQ), but there was one market that acted completely different: the Repo market.
What Causes A FTQ?
A FTQ is caused by fear, plain and simple. Market participants prefer safety to yield. In other words, they will do anything to NOT to lose money. Over the past 20 years, there have been several flights-to-quality which include: a terrorist attack, a hedge fund collapse, a major country default, a liquidity crisis of over-leverage, and the big-daddy of them all, The Financial Crisis.
What Happens During A FTQ?
Remember, a panic is not based on fundamentals. Yes, some are pricing interest rates lower to reflect the increased chances of a Fed rate cut, however, most of the distorted prices and rates are based on fear. When investors are worried they won’t get their money back, they’ll pay almost anything for an ultra-safe financial instrument. As a consequence, Treasury bills and short-term Treasurys rally considerably, stocks sell-off. To some extent, investors are gauging whether real economic activity will decline after the crisis. Of course, if the panic conditions continue, there will be less economic activity and the panic becomes the reality. However, over the past 20 years, only one FTQ was a prelude to a recession (The Financial Crisis). Otherwise, the distorted markets are generally short-lived and normal markets soon resume.
The Repo Market
In the Repo market, it’s all about supply and demand. There’s more demand for high-grade securities, like U.S. Treasurys, and there’s less supply available in the market. Investors who were normally enjoying higher yields in uncollateralized lending, like bank deposits, CDs, and CP, move their cash out of those instruments and into Treasurys and Treasury Repo. Bank CD, CP, and deposit rates move higher as there’s less investor cash in those markets. Treasury collateral trades at a wider premium below fed funds. Because many end-user customers do not loan their securities, it increases the borrowing premium for specials and leads to increased fails.
LTCM Collapse And The Russian Default Crisis: October 1998
In August 1998, Russia defaulted on its debt and the hedge fund Long Term Capital Management (LTCM) collapsed in October. During the crisis, the Street cut back on financing activity and many predicted a pending financial markets recession. The Dow dropped from 8,024 on September 15 to 7,726 on October 4, a decline of 3.7% The U.S. Treasury 10-Year note rallied from 4.90% to 4.16%, a rally of 74 basis points. At the height of the crisis, general collateral was trading 45 basis points below fed funds and there were shortages in every on-the-run Treasury.* However, the market mostly returned to normal by the end of November.
September 11, 2001
Following the terrorist attacks of September 11, the financial markets were effectively frozen for a week. This crisis was unique in one way: it was more an infrastructure crisis than anything else. The Bank of New York’s clearing function was effectively closed, so the entire settlements system was frozen. One month Treasury bills rallied from 3.40% on September 10 to a low of 2.00% on September 19. The Dow dropped from 9,605 to a low of 8,235 on September 21, a decline of 14.2%. The Treasury 10-Year note rallied from 4.84% to 4.50% on October 3, a rally of 34 basis points. In the Repo market, there was a very unique response. The market fixed inter-dealer Repo rates for a week at a 50 basis point spread. General collateral was fixed at 3.50% and specials at 3.00%. Though there was increased demand for Treasury collateral, one would expect significant Repo specials. It was the case in some issues but not in all. There wasn’t a significant widening of the spread between GC and fed funds because the situation was mostly due to the collapse in infrastructure. By November, all of the fails had cleared up and the Repo market was mostly back to normal.
The Liquidity Crisis: August 2007
After the collapse of Bear Stearns Asset Management in June 2007, two BNP Paribas funds and July, and Sentinel Capital Management in August, the market was caught in a drastic period of deleveraging. Market participants didn’t know who was holding illiquid securities, like CDOs, so there was a perceived increase in counterparty risk. Investors didn’t want to lend to banks and banks didn’t want to lend to leveraged funds. The period became known as “The Liquidity Crisis of August 2007.” Fear of insolvent banks was so great that the bank CD market all but shutdown. A massive amount of cash moved out of banks and into Treasury securities. The Dow declined from 13,362 on August 1 to 12,845 on August 16, a drop of 3.8%. The 10-Year note rallied from 4.76% to 4.60%, and one month Treasury bills went from 5.05% to a startling 2.47% on August 20 – a move of 258 basis points. Repo rates followed the bill market, trading 277 basis points below fed funds for a few days. The depth of the crisis was over by mid-September, but the period was marked by an unprecedented premium for high-quality assets.
The Financial Crisis: September And October 2008
No one can fully explain The Financial Crisis in just one paragraph. Overall, financial institutions collapsed, stocks declined, the CD market shutdown, Treasurys disappeared, and there was a massive amount of Treasury fails. Investors pulled out of the financial markets for fear of the next collapse. From September 12 to the beginning of October, the Dow dropped from 11,421 to 8,451, a decline of 26%. One month bills rallied from 1.37% down to 0.13% on September 24, yet the Treasury 10-Year note barely budged, only rallying from 3.74% to 3.48%, a total of 26 basis points. In the Repo market, GC traded 500 basis points below funds on September 30, 2008. The specials situation in 2008 was somewhat unique. The Fed was rapidly cutting overnight rates and there was no Fail Charge at the time. Though demand for Treasurys and settlement fails were astronomical, it wasn’t fully reflected in Repo rates because GC rates were so close to zero anyway.
Last Week’s Mini FTQ: October 2014
During last week’s bond market “flash crash,” the Dow sold-off 8% at its low, and the 10-Year rallied 35 basis points, though it moved as much as 63 basis points based on its intraday low. Both in the ballpark of a flight-to-quality. However, Repo rates actually moved higher during the panic; the exact opposite of a normal FTQ. For one day, GC traded 11 basis points above fed funds. In the past, when GC rates traded above fed funds, it either meant the Street was extremely long the market, bank’s had balance sheet restrictions that prevented them from arbitraging the two markets, or the Treasury was over-issuing debt. None of those factors were really true for that one day.
Was there a FTQ last week that was different from others in the past? Perhaps last week’s FTQ was minor and not a full blown panic, but still the 10-Year note rallied like there was no tomorrow. Perhaps there’s been a fundamental change in the market due to something like QE, new bank regulations, and less bank intermediation. Does last week’s bond market “flash crash” represent a growing dysfunctional market? There’s clearly some fundamental changes occurring in the market, I can’t explain them now but expect more confusing Repo market trends in the near future.
* The Specials Index is the average spread that on-the-run Treasurys trade below general collateral