The financial system’s metabolism isn’t looking too hot. 10Y treasuries crashed to -4% in the overnight repo market, a sign of critical illness.
The move is an entire basis point below the Fail Charge, demonstrating that something is deeply wrong with the financial system’s plumbing. Such a crash has far-reaching implications, especially for the now-bullish commodities sector.
But if you’re not an economist or working at a trading desk, this may all seem inconsequential.
What is the repo market? What’s a Fail Charge? How in the world does this obscure overnight market relate to commodities? Let’s connect the dots and shine a light on this complex but critical issue.
Repo Rates and Fail Charges
The repurchase agreement, or repo, market is an overnight market in which large banks sell government securities to one another to cover overnight positions, the most liquid of which are US Treasuries with a ten-year yield (often referred to as 10Y Treasuries, or simply 10Ys).
10-year Treasury Yields
Some banks have an excess of 10Y Treasuries while others have a deficit – the repo market is where they make ends meet and secure a small profit along the way.
Most repos expire the next day, with the difference between the buy and sell prices representing the overnight lending rate. You may have heard this called “overnight lending.”
Any trades in the repo market must remain within a range of the Fed’s effective set funds rate or face penalties. It’s an imposed price range that large and vital banks pay for the privilege of being first in line for newly issued Treasury assets. If demand suggests a higher premium, the Fed simply increases the supply to assure banks stay within their imposed range.
Occasionally, a bank tasked with delivering purchased securities fails to find a counterparty in the repo market. Often this failure is due to a clerical error rather than a lack of willingness or ability.
Excessive failures to deliver securities harm the market’s overall efficiency — something the Fed doesn’t appreciate.
When a bank experiences failures deemed excessive by the Federal Reserve, it receives a penalty known as the Fail Charge. The charge is a maximum of 300 basis points, or 3%, less than the effective Fed fund rate’s lower bound.
But it went lower than that.
Overnight Rates for 10-Year Treasuries
Banks are naturally self-interested and willing to take on a bit of short-term pain if it means significant long-term gains.
For that reason, the Repo market is freezing over as many banks are hoarding stashes of US treasuries, willing to pay the Fail Charge all the while.
Lower Than Failure
In today’s environment, that Fail Charge amounts to a -3% rate, indicating a bond that’s incredibly hard to borrow.
The actual numerical amount isn’t what’s important. The most critical detail is that the rate itself is negative, meaning the borrower is paid interest by the lender, not the other way around.
It is essential to understand that never before in history has a Treasury security traded this far below the Fail Charge until last week.
It’s an unprecedented shift lower, representing a titanic shortage of liquidity in the Treasury market. For the moment, there simply aren’t enough Treasury securities to go around.
You likely realize the disconnect explained here shouldn’t occur. Treasury securities are readily available, and the 10Y is the most liquid security in the world. For banks to shift their preferences, seemingly overnight, to a position of intense skepticism means the financial system’s inner workings are beginning to buckle.
The last time 10Y Treasury liquidity fell to such lows was at the height of the Covid-19 crisis, and even then, rates never slipped below the Fail Charge rate for very long.
Primary Dealer Holdings of Longer-Term US Treasuries
Worryingly, this isn’t the first time the repo market experienced sudden and intense shocks.
In September 2019, the repo rate skyrocketed, more than doubling from 2.5% to 5% overnight, causing the entire market to behave erratically.
It took an 11% increase of the Fed balance sheet to unclog the financial pipes and normalize the overnight lending rate.
While an 11% increase is a meager amount compared to the Covid-19 balance sheet explosion, such an increase is no small amount. For the Fed to take such decisive action shows how quickly things can unravel in the financial system and that it takes a massive response to get things back to normal.
You can guarantee the market is ill when the most liquid security in the world is being hoarded by major banks.
It demonstrates a massive short position in the US Treasury market. Bond yields and price are inversely related, meaning banks expect yields to continue to rise, suggesting chronic inflation on the horizon.
Unstoppable Force, Immovable Object
The repo market is the “canary in the coal mine” for US inflation, and it’s starting to break down yet again.
The Fed simply cannot leave the repo market in chaos. September 2019 showed us that they’re willing to go to any lengths to assure that the interbank lending system remains as orderly as possible.
Otherwise, the entire financial system could freeze and buckle due to a complete lack of liquidity. Current financial problems require modern financial solutions.
Additionally, financial institutions are becoming increasingly worried about how the Fed will handle rates. With inflation expectations surging, the financial world expects the Fed to get ahead of this tidal wave of price increases by raising rates. If the Fed refuses to blink and keeps rates too low for too long, inflation could run very hot.
It’s a catch 22 for both the Federal Reserve, major banks, and the purchasing power of your money.
Why the massive inflation expectations and speculation?
The Fed’s balance sheet has already doubled from 2019, thanks to a combination of the repo and Covid-19 chaos.
Monetary velocity is down, but as economies begin to reopen, inflation expectations are steadily rising. If the Fed was thinking about unwinding its balance sheet to avoid a surge in inflation, this week’s repo chaos has them rethinking those plans.
Powell tried to jawbone the issue. The S&P went red for the year, with the NASDAQ following suit. The Fed is between a rock and a hard place, and massive amounts of consumer inflation are all but assured.
One thing the Fed cannot control, at least directly, is the rate of commodity production. The prices of timber, copper, steel, oil, and land are all rising rapidly.
Central banks are calling this the beginning of another commodity supercycle. Given commodity price’s historical correlation with inflation, we’ve set the stage for both an epic commodity bull market and an epic surge in inflation.
The repo market may not be the end-all for financial markets, but it indeed serves as a canary in the coal mine for the Fed’s balance sheet and subsequent inflation.