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Bonds, Future Bonds

Great. Just when you thought it was safe to go back in the bond market. The Wall Street Journal has covered this story for the last couple of days, but there's kind of a technical component here, so hold on. (Hugh, I'll try to explain it so even you can understand. Stop laughing, Duane.)

It turns out that there's an ongoing, periodic liquidity crisis in the 10-year Treasury Bond Market. Why does this matter? We'll get to that in a moment, but first, let's explain how this could possible happen in someplace where the word "republic" isn't preceded by the name of a fruit.

The problem is a shortage of actual bonds available to deliver when futures contracts close. It came to light in June, when a huge bond fund, PIMCO, found itself with very, very large position in 10-year futures contracts. Normally, it has no interest in taking delivery of these bonds, so it would just sell the contracts to close, and buy September contracts to replace them. But the September contracts were expensive, so PIMCO decided to hold onto the June positions, and go ahead and take delivery of the bonds. (They informed the Chicago Board of Trade of this, in order to avoid the appearance of manipulating the market.)

Here's the problem: there aren't enough bonds to fill the deals. Bond futures holders normally only take delivery about 10% of the time. (In fact, the CBOT, when it discovered the problem, implemented a rule that futures holders couldn't ask for more than 10% of bond in delivery, immediately driving down the price of those September futures and costing traders even more money.) So when PIMCO signaled that it reallly was going to expect those bonds at the end of June, it set off a scramble to find bonds to deliver.

There's another bond market that doesn't get as much play in the press - the repurchase, or repo market. That market is basically a short-term lending house for bonds, much like your credit card is, or should be. Naturally, with all these 10-year bonds out on loan, PIMCO's sudden need for bonds created a shortage, or squeeze, in the repo market, too.

This means a couple of things. First of all, look at the 10-year interest rate.
There's a noticeable, half-point drop bottoming out at the end of June. But there's still plenty of downward pressure on 10-year rates, because everyone knows the same thing is going to happen in September. People are holding onto those bonds, because 1) they want to be sure they have enough to deliver, and 2) they expect the price to rise, and thus the yield to fall. It also means that for the time being, the repo market is likely to be less liquid, putting downward pressure on short-term rates.

It's likely that this will work itself out to some degree, but it also means that the massive foreign appetite for our Treasuries is responsible for that flattening yield curve everyone's worried about. This time, though, it may not presage a recession.