Repo Architect Issues Dire Warning

12/12/2019 9:44 am EST

Focus: STRATEGIES

Jeff Greenblatt

Director, Lucas Wave International, LLC

The massive purchases by the Fed since September—which they have dismissed as ordinary maintenance—is catching the attention of people in the know, reports Jeff Greenblatt.

Many of us have speculated why the Federal Reserve has been injecting several trillion into the repo (repurchase agreement) market since September. Today Tyler Durden at Zero Hedge may have finally come to the bottom of it. He talks about a dire warning issued by Zoltan Pozsar. You probably never heard of Pozsar, but he’s among the most respected names on Wall Street as he is one of the few individuals that completely understands the modern repo system because during his tenure at the Treasury Department and New York Fed he helped created the foundation for the system. In short, he’s the modern day E.F. Hutton. When Mr. Pozsar talks, everyone needs to listen.

The best I can do is a review of Durden’s fine article called, “It’s About to Get Very Bad” – Repo Market Legend Predicts Market Crash in Days. He offers a look behind the curtains of the very complex system of how the Fed works, in addition to the roles played by foreign banks, dealers, hedge funds and others.

Here’s the problem. As a portion of the liquidity pool, the big banks had 42.6% in 2017, 41.2% in 2018 while that number has dropped drastically to 31.3% this year. This is the average ratio of the top six banks as defined by global liquidity rules at the end of each year’s third quarter. What has happened is the banks moved away from reserves and purchased collateral in the form Treasuries. Pozsar explains that “dealers and banks loaded up on collateral as a trade they were supposed to be taken out of by eventual coupon purchases by the Fed.” Coupon bonds means the bondholder gets an annual interest rate payment to maturity. But that didn’t happen. Key in on the word eventually. What happened was starting in October the Fed issued Treasury bills instead because Fed Chair Jay Powell wouldn’t have to call it QE. Since these bills don’t have duration, it’s not QE. By buying Treasuries, commercial banks are not allowed to exchange their coupons for cash reserves. This is one of the complexities where a rocket scientist is needed.

Why we may be on the cusp of a crisis is the fact the yearend turn is coming and everything has to balance out. It did not do so at the end of the last quarter as it is true banks had serious problems making a September tax payment because they were so short on reserves. As it turns out, another tax payment is due next week again on Dec.16, the same day President Trump is supposed to announce whether there will be a reduction in tariffs on the trade war front.

But there’s more. Fed action has done nothing to boost or sustain reserve levels. There is a global systemically important banks (G-SIBs) surcharge imposed by regulators on U.S. banks on the last day of the quarter and the year. Each bank has a G-SIB score and it determines what banks are allowed to do with whatever excess reserves they have at yearend. What they usually do is lend through repos, spend on Treasuries or lend through FX swaps. Higher scores mean a higher surcharge and every one of the big boys, with the exception of Morgan Stanley, needs to lower their score.

Here’s one of the biggest problems. The higher stocks rise, the higher the G-SIB score. The stock market rally is inflating scores through G-SIB market capitalization. In other words, one way to shrink those scores would be a market selloff. That’s precisely what happened last year at this time even as excess reserves were $100 billion more than they are now. What banks need to do from now to the end of the year is swap assets for excess reserves. This year the excess reserve market has collapsed.

Pozsar says at least one U.S. bank is pricing some of its FX swap trades because its planning on missing the payment, which means its planning on a collapse of the FX swap market. The idea is to force a market crisis so the Fed will have to launch full blown QE4 where they would get bailed out. Bottom line to all this? Large U.S. banks do not have excess reserves to lend, last year they got G-SIB relief due to the 2018 correction in stocks, this year they will not have such fortune.

Finally, hedge funds are involved here as well and they’ve been buying Treasuries while selling equivalent interest rate futures. They’ve been pocketing the arb or difference in price. This can only work out for them if interest rates remain stable. What has to happen according to Pozsar is the relative value hedge funds community needs to have the balance sheet to fund their bond basis trades at a reasonable rate by the end of the year. The problem is they don’t know what the rate is going to be.

Let’s put the bow on it. With excess reserves drying up and G-SIB scores too high, the FX swap market may trade at implied rates far worse than anything this market has seen in recent yearend turns. Dealers could end up as forced sellers of Treasuries. Pozsar warns that Treasury yields could spike and what could happen is a series of liquidations beginning in the FX swap market and ending with stocks.

I’m going to show you the current state of the state in the two-year/10-year spread. The two-year note is probably more applicable to this discussion but let’s look at the 10-year first. It’s in bad shape. For the intraday situation on a 180-minute chart it has already broken below a larger Andrews channel and right now polarity is in the process of flipping to the bearish side at a 38% retracement on the 39th bar (see chart).

two-year note 

Wednesday it was holding but its troublesome below a magnet/trend line, which now has its path of least resistance pointing down. For the two-year note we are looking at a configuration of .33 up at 34 days which was retested and now turning lower. Its sitting at support with a bearish Andrews channel (see chart).

magnet/trend line

 If it breaks down, all the calculations of these hedge funds could go up in flames. What appears to be happening is the Fed has been attempting a race against time to front run the system to prevent a very bumpy yearend turn for banks and other institutions.

Nothing is set in stone yet, Pozsar says the Fed still has a couple of options but one of them is a massive QE4 which they could only do after a crisis hits. This is a serious read for traders who want to have a better understanding of what few have explained and even fewer understand.

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