We're Now Frighteningly Vulnerable to a Bond Market Crash
Interest-Rates / US Bonds May 28, 2015 - 07:21 AM GMTBy: ...
MoneyMorning.com 
Shah Gilani writes: Water doesn’t flow uphill.
It’s a lesson in physics so basic that even schoolkids know it.
In fact, everyone knows it…
Everyone except – apparently – the world’s central bankers.
In their rush to provide liquidity to banks through experimental stimulus programs like “quantitative easing,” central banks have failed to create the usual cascade of liquidity normally associated with massive money-printing shenanigans.
Indeed, by attempting to force-flow money uphill, liquidity in the all-important bond markets essentially has been drying up. Central banks have been taking bonds out of circulation, warehousing them on their own balance sheets.
As a result of this attempt to defy the laws of financial physics, we’re now frighteningly vulnerable to a bond-market crash. And the best potential remedy – opening the sluice gates – can’t be employed because liquidity isn’t in the reservoirs where it’s needed.
Today I’m going to show you how this financial-market Disruptor came into being. I’m also going to explain how ruinous it could be to the economy, to the bond market, to the stock market and to you.
I’m also going to show you how to turn this expected “Disruption” to your advantage – to make money from it…
Upending the System
Quantitative easing (QE) is a special Disruptor.
In fact, it’s the biggest financial Disruptor ever.
In the past, when the U.S. Federal Reserve wanted to do its part to stimulate the economy, it might first announce its intention to lower interest rates – and might even announce a “target rate.” The interest rate they targeted was the “repo” rate.
Repos, short for repurchase agreements, are very-short-term interbank loans where one bank offers up U.S. Treasury bills, notes or bonds as collateral for an overnight loan from another bank – and repurchases (buys back) that collateral the next day, or a few days later, depending on the term of the repo agreement.
When that first bank buys back its collateral, it pays a little more than it borrowed – which is the “interest” the lending bank earns.
That interest, when expressed in percentage terms as a “rate,” is the overnight rate, or the “repo rate” – and serves as the base rate for all banking loans.
If banks can borrow cheaply from each other because the repo rate is low, they will borrow a lot and use that money to make loans throughout the banking system.
The Fed doesn’t directly control the repo rate by mandating what it is. The repo market is a free market where the repo rate is set by traders engaged in repurchase agreements every day. All big banks have repo desks.
If Fed central bankers want to lower the repo rate, they can announce what they want it to be. But that doesn’t always cause repo traders to adjust the rates they charge for overnight loans.
So, the Fed has its New York Bank – which conducts all the U.S. central bank’s “open-market operations” – actually go into the repo market and offer loans at cheaper rates than other banks are offering. In other words, it’s effectively trading overnight money by making it more available in order to bring down the cost of overnight borrowing by big banks.
That Old Profit Model
In theory, that cheaper base-borrowing rate for banks that I just described for you is supposed to work its way through the financial system. By that I mean it’s supposed to get translated all down the line into cheaper loans for banks’ commercial and retail customers.
During the financial crisis, big banks weren’t lending to each other. They were actually afraid that their “counterparties” – the other big banks – would go out of business… meaning the money they loaned might not be repaid.
The repo market essentially seized up.
And that left America’s central bankers with a big challenge.
The Fed, you see, needed to jump-start the system. It had to create “liquidity programs” that would flood banks with money so they could meet depositors’ withdrawal requests, meet their reserve requirements and continue to fund their outstanding loans, most of which have to be “rolled over.”
Banks have to constantly roll over the short-term loans they’ve taken – and for a very good reason. While banks actually “lend long” in their core business, they obtain the money they use to make those loans in short-term markets – like the repo market.
That makes their “cost of money” cheap. And it boosts the profits they make on those loans by widening the “spread” between what they paid on the money and what they earned by lending it out at higher rates.
That spread is known as the “net interest margin,” or NIM.
Backed Into a Corner
That brings us back to the struggles of the U.S. economy during the Great Recession.
There wasn’t any real loan demand because the economy was flat on its back. And that already precarious situation was heightened by the fact that interest rates were still relatively high because banks didn’t want to make loans, period.
The Fed had to act.
And it did.
The U.S. central bank started by flooding big banks – which were already on life support – with the liquidity needed to stay alive.
But that was just the beginning.
The Fed then started lending money to big banks – first by doing direct, longer-term repos and taking their U.S. Treasuries as collateral… and later by taking nontraditional assets like mortgage-backed securities (MBS) as collateral.
When that wasn’t enough to ensure the future of the banks and stimulate the economy, the Fed came up with quantitative easing – known colloquially as “QE.”
Quantitative easing simply means interest rates are as low as the market can push them. To achieve further progress – and lower rates more – the Fed now has to engineer “quantitative purchases” of banks’ assets.
By buying Treasuries and MBS from banks in massive quantities, the Fed was flooding banks with cash.
That central bank move achieved two objectives. First and foremost, it healed banks’ balance sheets. Second, it infused those banks with cash to make loan money available at cheap, economy-igniting interest rates.
If you think that sounds like the happy ending to an economic-crisis tale, think again.
It’s actually the beginning of an ugly story – even a horror story – that details the situation we face right now.
The Bloodbath to Come
In all, the Fed purchased more than $4 trillion worth of banks’ Treasury bills, notes, bonds and mortgage-backed securities.
While the Fed was taking Treasury inventory off the market – and warehousing it on its own balance sheet – stricter capital requirements were being levied on banks.
That brings us to the topic of bond-market liquidity – which is really all about Treasury inventory.
Banks use U.S. Treasuries as liquid instruments, which they point to when they calculate what they are holding in capital reserves. Banks have to hold reserves on everything. They even have to hold reserves against the cash they hold.
When banks need money overnight to meet their reserve requirements, they usually go into the repo market and lend their Treasuries as collateral for overnight loans.
But those banks don’t have as many Treasuries as they used to. There aren’t as many in circulation.
Those Treasuries are sitting in the vaults of the U.S. Federal Reserve.
Hedge funds, including “funds of funds,” which currently hold more than $3 trillion in assets, use Treasuries as collateral to borrow from banks and prime brokers to finance their risky bets. There aren’t enough Treasuries for them, either.
The $2.5 trillion money-market-fund industry buys Treasuries as liquid investments with the cash investors deposit with its funds. But they’re having a hard time finding enough inventory.
At the same time, America’s annual federal budget deficit is shrinking and tax receipts are picking up. That means the government won’t have to issue as many Treasuries as it’s been issuing in the past. That’s going to further reduce the inventory of Treasuries.
And this dearth of Treasuries poses a serious liquidity problem.
Very serious…
In a panic, the “flight to quality” trade is into Treasuries. Only in the next panic, there won’t be enough. There just aren’t enough Treasuries out there.
In a panic, asset prices plummet, and holders need to meet margin calls with Treasuries as collateral. Bond prices fall because sellers can’t put up liquid Treasuries as collateral to hold their positions. Falling prices of financial assets fall – creating buyable bargains – but speculators can’t put their hands on Treasuries to use as the collateral needed to grab those “distressed” assets.
When that happens, what’s going to save us?
The Fed can’t just sell the Treasuries they have.
It’s going to be ruinous. It’s going to make 2008 look like a day at the beach.
And massive numbers of investors will be clobbered when that scenario I’ve sketched out plays out.
You could be, too.
Or you could make a fortune.
Next time, I’ll show you how…
Money Morning/The Money Map Report
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