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The Fed is Not To Blame This Time As Treasuries Sell Off, But There’s a Lesson Here

Be sure to read the latest on this, Blame China Here’s Why, and Fed Will Taper If Economy Goes As Forecast- Uh Oh! Fed Sucks At Forecasting

Lately the Wall Street and media noise machine has taken up the Fed bashing bullhorn in conjuring a “reason” to explain the recent selloff in Treasuries. In fact, the Treasury market has been in a bear market for almost a year, with yields making higher lows and higher highs since last July. Admittedly, the Fed’s disjointed, multivoiced, multimode elephantine dungheap of a communications policy has had the effect of confusing both the punditocracy and big mahoff investors. But I don’t think that that’s the main cause of the turn in the bond market from bull to bear.

In my view, the primary impetus for that turn is that the giant banks who get funding from the ECB–which means essentially all the multinational market behemoths– are rushing willy nilly to repay hundreds of billions in ECB loans. These largely include the massive emergency loans made under the LTRO program in late 2011- early 2012. The ECB had given hundreds of billions of these loans with a 3 year term, with an option to repay after one year.

A few of the banks did not want those loans in the first place, but the ECB shoved them down everyone’s throat so that the banks who really did need them would not be stigmatized. This is the “theory of collective guilt” that central banks apply when forcing emergency funding into the world’s banking system.  The central banks don’t want to call attention to which banks are stronger and which are weaker. All must be seen as equal. Equally shitty.

Being forced to take these funds, some of the banks decided to park  a portion of them in US Treasuries, thereby collecting the spread – free money for the banks. In the process of loading up on that paper to set up this carry trade they drove yields to all time lows in July of 2012. Based on the promise of low yields from the central banks, some of those banks took on additional risk by going out longer on the yield curve.

Suckers.

Meanwhile, the few “smart money” bank money managers were beginning to take advantage of that.

While some banks were loading up on Treasuries in the final buying orgy last summer, other banks began slowly paying down shorter term ECB loan programs. They were apparently getting a head start on the deluge of repayments they knew would be coming, because they themselves had planned to do the same as soon as that one year repayment window opened in January 2013. Take the carry for a year and get out while the gettin’ was good. The banks that had used some of the original loan funds to buy Treasuries would need to liquidate that paper (or something else) in order to repay the ECB and close the books on their short term carry trade.

That is exactly what happened and is happening. Banks are aggressively selling the Treasuries and other paper that they had bought with the LTRO funds to pay down the LTRO loans. Lately they have been forced into a bit of a panic– a long squeeze–to do so. Carry trade losses are mounting, and so is the selling in the Treasury market.

At the same time, rising yields send a signal to the dumb smart money to buy stocks, leading to the final blowoff of that bubble.   But this shrinkage of the ECB balance sheet is making the bubble blowing jobs of  Ben (Bernanke) and Abe (Nomics)  jobs much harder as they continue to pump QE funds into the same banks, but that’s a story for another post.

ECB and US Treasury Market
ECB and US Treasury Market – click to enlarge

So it would appear that the Fed is not entirely to blame for the bond market dislocation, neither for the final blowoff of the that market in mid 2012, nor for the inevitable selloff that had to follow. No, Bernanke bashers (count me in as a card carrying member), it wasn’t Uncle Ben this time. It was Super Mario and friends at the ECB. The process of the banks sloughing off those unwanted ECB loans and disposing of the underlying assets while frantically attempting to delever and derisk their balance sheets  is what is sending Treasury yields soaring.

There’s no end to that in sight. The Fed is probably constrained from buying enough paper to compensate for this wave of liquidation.  Tomorrow it will only add to the confusing and contradictory messages that it has been sending, regardless of what it says. I don’t think that the bond market will be soothed for very long, regardless of what the Fed says.

Finally, put this in your pipe and chew it. A similar process is going on with the Fed and BoJ’s QE programs, which are targeted at stock prices. The banks are in some cases buying stocks as a parking place for that money, although unlike the ECBs’ LTRO, the Fed’s QE is open ended and outright cash purchase funding with no finite end date.  Playin the Fed’s game has been so much easier. But as with the repayment of the ECB loans the underlying assets would get sold if the Fed ever tried to unwind QE. That would lead to a violent reaction in the opposite direction of the bubble that has grown out of QE.

I think that Dr. Evil, Ben Bernanke, may have checkmated himself. Taperophobia  is not an irrational response.

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I’ve been watching the Fed’s operations every day ever since it started publishing them daily in 2002 along with its balance sheet and the commercial banking system balance sheet weekly. As the famous financial philosopher L. Berra wisely said, “You can observe a lot by watching.” I invite you to watch along with me, and observe a lot.

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3 Comments

  1. KenM

    Have not heard of this from anywhere else. Should be interesting to see if any followup from the big bond boys

  2. Yancey Ward

    Ok, let’s say you are correct about the LTRO (and I am not saying you are)- won’t we start realizing which of the big behemoth banks were truly shitty because they are the ones that aren’t unwinding the carry trade early and paying the ECB back the borrowed funds? Why wouldn’t the ECB reinstitute a “must play LTRO” again to hide this information? I am just not sure your hypothesis makes a lot of sense.

  3. black swan

    Two things, Lee. First, the Chinese have also been dumping Treasuries. Second, where’s the unwind of the carry trade between the Fed and the TBTF banks?

    One other thing worth mentioning is the carry trade between any bank using ZIRP dollars to buy higher yielding emerging market bonds. That’s becoming another big unwind. The ECB is only one of the major players in this drama.

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