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Is The Government Bond Bubble Getting Ready To Burst?

Posted by Larry Doyle on April 30, 2009 5:45 AM |

The equity markets have rebounded significantly over the last seven weeks. The Dow and S&P are now down approximately 4-6% on the year. The tech heavy Nasdaq has distinguished itself and is up approximately 10% on the year.

At this juncture, if the equity markets are implying that the economy will not slip into Depression, then the bill for the stability in equities is being transferred to participants in the bond market. Government bonds are facing an almost weekly avalanche of tremendous supply. This week the market is absorbing over $100 billion in 2yr, 5yr, and 7yr Treasury securites. Take a deep breath and next week the market is faced with over $75 billion in 3yr, 10yr, and 30yr government securities. The Treasury is likely going to sell 30yr government debt on a monthly basis!! 

The Federal Reserve has been the biggest buyer of Treasury and mortgage-backed securities. The Fed’s balance sheet may be large but it is not endless. What have 10 yr. Treasury securities done on the year? Even in the face of massive buying of these securities by the Fed, the 10yr has backed up almost 1% to a current level of 3.1%. That rise in rates is very significant. 

I have maintained and continue to maintain that interest rates will move higher given the overwhelming demand for funds by global governments to pay for deficit spending. Central banks around the world may try to hold the respective bond markets up and interest rates down but investors will continue to demand a higher rate of interest in the process. 

As government rates move higher, mortgage rates, and other corporate rates will likely move higher as well. If we get a whiff of early signs of inflation which I believe is coming these rates could ratchet higher and the bubble in the government market would not merely burst but would actually explode.


  • fiscalliberal

    Data Point for a 70K CD at 5/3 Bank in the Detroit Suburbs is 11 months for 2.07%. Savings account is 1.6%

    Looks like there is a lot of room for improvement. It is my understanding that if the stress tests were released Friday, the banks should know what their capital requirments are. If they needed capital, I would assume one of the paramaters would be higher CD rates. Or they are counting on the government to flood them with capital.


    • Fiscal…As long as the Fed keeps the funds rate at 0-.25 %, which it will for an extended period, CD rates may not go up much. The government will likely inject more capital.

  • bonddadddy

    oh come now Larry …. unlce Ben will wave his magic wand and make a few trillion more UST and mbs disappear ….. i spotted FNMA 4’s at +81/10yr yesterday on Bloomberg …… somebody ( like a PIMCO ) unloaded piles of agency mbs today into this insane bid by Fed and now much wider . Bernanke will lose hundreds of billions before this is over buying at alltime peak ……. ( ya think Street can margin call Fed on underwater repo positions ? )

  • bonddadddy

    from the guys who made shorting banks illegal —

    …..comes the new penalties that make shorting US Treasuries far more expensive …………… the unintended consequence will be a far smaller short book by investors leading to massively higher levels of volatility in bond yields ……. Bernanke will employ any tactic in his quest to manipulate the markets ……. this guy truly begins to scare me at what steps he will take and why i actually believe Lewis that Bernanke threatened him to close on MER ‘or else’

    Repo Failure Remedy Drives Away Short-Sellers in Treasuries
    2009-04-30 04:00:01.2 GMT

    By Liz Capo McCormick
    April 30 (Bloomberg) — Just as Federal Reserve Chairman
    Ben S. Bernanke revives credit markets, one of his remedies
    may reduce trading in Treasuries.
    A Fed-endorsed industry recommendation will require
    traders to pay a three-percentage-point penalty on
    uncompleted trades, known as fails, starting tomorrow. That
    may reduce the number of bets on price declines, according
    to RBS Securities Inc. and Societe Generale SA.
    While the new recommendations are meant to curb disruptions
    caused when traders fail to meet their obligations, some
    strategists are concerned it may do more harm than good in the
    $7 trillion-a-day repurchase market, where dealers finance their
    holdings. A reduction in trading would be a setback for the Fed
    as it seeks to lower borrowing costs by pumping cash into the
    banking system and purchasing as much as $1.75 trillion in
    Treasuries and mortgage securities.
    “Making short-selling potentially costly can reduce market
    liquidity,” said Darrell Duffie, a Stanford University finance
    professor and member of the New York Fed’s Financial Advisory
    Roundtable. “Financial markets with relatively unencumbered
    short-selling perform better.”
    The U.S. needs to raise $3.25 trillion this fiscal year to
    finances bank bailouts, stimulate the economy and service a
    deficit, according to New York-based Goldman Sachs Group Inc.,
    one of the 16 primary dealers that trade with the Fed.

    Trading Decline

    Trading is already down, with volume done through the
    primary dealers averaging $363.6 billion a day this year,
    compared with $655.6 billion in the same period of 2008 and
    $533.3 billion in 2007, according to Fed data.
    Interest rates near record lows and surging demand for the
    safety of Treasuries pushed the amount of bad trades to a record
    $5.3 trillion in the week ended Oct. 22.
    Federal Reserve Bank of New York President William Dudley,
    who succeeded Geithner in January, said during a Nov. 12
    interview that U.S. borrowing costs could rise if the logjam in
    the repo market, which dealers use to finance their holdings,
    wasn’t rectified. The New York Fed said Jan. 15 that it endorsed
    the Treasury Market Practices Group penalty recommendation, as
    well as other measures to reduce fails.
    The penalty proposed by the TMPG, an industry committee
    formed by the Fed in 2007, would add an incremental cost of
    $833.33 dollars per day on a failure of $10 million worth of
    bonds, according to data compiled by Bloomberg.

    Securities as Collateral

    In a repurchase agreement, one party provides securities as
    collateral to another in exchange for cash. The penalty would
    result in the lender receiving a reduced amount when it delivers
    the Treasury late.
    “Where market makers may have felt comfortable in the past
    making outright short sales to investors, there certainly has to
    be a greater consideration of these negative costs,” said Ken
    Silliman, a Treasury bill trader in Greenwich, Connecticut, at
    RBS Securities Inc., another primary dealer. “The fails penalty
    has risk of reducing liquidity in bills and Treasuries all along
    the yield curve.”
    Investor confidence in financial markets is returning after
    the U.S. government and the Fed agreed to spend, lend or commit
    $12.8 trillion to end the longest recession since the Great
    Depression. The London interbank offered rate, or Libor, for
    three-month loans in dollars fell yesterday to 1.03 percent, the
    lowest level since June 2003, according to the British Bankers’

    Target Rate

    Yesterday, the Fed refrained from increasing purchases of
    Treasuries and mortgage securities, signaling the worst of the
    recession may be over, as it kept the federal funds rate target
    at a range of zero to 0.25 percent for the third straight
    There is little incentive to make good on delivery
    commitments when rates are close to zero because the main cost
    for failing to deliver a borrowed security is the loss of
    interest that would have been received on the money lent to
    obtain it.
    Overnight general collateral repo rates were about 0.20
    percent yesterday, according to GovPX Inc., a unit of ICAP Plc,
    the world’s largest inter-dealer broker.
    “If you have fails, then the market isn’t functioning
    properly,” said Eric Liverance, head of derivatives strategy at
    UBS AG in Stamford, Connecticut, another primary dealer. “That
    is what we saw last fall when we had massive fails. If you can
    lend a bond out and count on it coming back the next day, then
    those are properly functioning markets and it enhances

    Going Long

    Trading failures fell to as low as $81.06 billion in the
    week ended April 8, before rising to $272.4 billion the
    following week, according to New York Fed data.
    Primary dealers typically short Treasuries as a trading
    strategy to hedge their holdings in other securities. That’s
    changed this year, leaving them “long,” in part, because of
    the new repo recommendations. They held $75.1 billion of
    Treasuries as of April 8, the most since at least 1997, compared
    with an average of minus $60.6 billion, Bloomberg data show. The
    amount fell to $60.6 billion as of April 15.
    “That is telling you that dealers really don’t know what
    all this will mean,” said Donald Galante, chief investment
    officer and senior vice president of fixed income at MF Global
    Ltd. in New York. “People are being prudent and saying I am not
    going to have a Treasury short now and I’ll wait to see how this
    pans out over the next two months.”
    Galante advised his traders to not take short positions in
    the repo market or in short-term Treasuries going into May to
    allow time to analyze how the penalty and movements in repo
    rates evolve.

    Below Zero

    The threat of penalty will likely cause repo rates to drop
    below zero on Treasuries that have had high levels of fails or
    whose rates have traded close to zero in the repo market,
    according to Ira Jersey, head of U.S. interest-rate strategy in
    New York at RBC Capital Markets. Jersey cited the current five-
    year note as an example. The repo rate on that security was 0.05
    percent yesterday, according to GovPX.
    A negative repo rate means that investors who lend cash in
    exchange for obtaining securities as collateral actually pays
    interest instead of receiving it on the money they loan.
    Penalties for uncompleted trades will begin to accrue May
    1. The due date for filing claims for fails to counterparties in
    trades that occur in May will be June 12, and payment or claim
    rejections will be due on June 30. In subsequent months the
    filing date will coincide with the 10th business day and the
    payment date will be on the last business day of the following

    ‘State of Anxiety’

    Because the penalties will be imposed across the government
    debt market, unregulated investors such as hedge funds will be
    held to the same standard as banks and bond dealers. Since it’s
    a recommendation, some dealers are still uncertain which
    counterparties will need to pay the penalty.
    “The market’s heightened state of anxiety looks likely to
    produce unintended and unfortunate consequences,” said Ciaran
    O’Hagan, the Paris-based head of fixed-income at Societe
    Generale. “The fails penalty adds to the security of the market
    at the cost of liquidity. All this suggests that liquidity will
    be hurt across the board for U.S. Treasuries.”

    • Daddy…..Awesome color. Much appreciated. Market manipulation always comes with a price. If traders fail, they should be forced to buy the fail in after a period of time. Big Ben also trying to have his cake and eat it too.

      Watch market participants take their bat and ball and go play on another field. If you want and need players in the shell game, you can’t also tilt the table.

      Your color is DEEPLY appreciated.

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