Thursday, May 14, 2009

The Debts of the Spenders: Penalty Fees for Secondary Bond Market To Keep Floor on Interest Rates

This should put a floor on interest rates from going too low. Failures to deliver were traditionally a big problem in the US govt bond markets. It got to ridiculous levels last December- early January when treasuries spiked and interest rates plunged. The timing was strange too: December - January is traditionally a period known as the "January Effect" when MM's take advantage of the light holiday volume to pump the market in their chosen sector. In other words, equities rallied but bonds rallied too. Normally, there is an inverse relationship between the two.

I am also assuming that these recent fees are part of the Fed's plan. Allowing SOME measure of inflationary creep is desirable to stimulate private lending again (b/c it makes commercial bonds more attractive on a yield basis) and drives the stock markets higher (b/c ultra-low rates begin to trigger penalties among fund managers who can't charge much for holding secure paper).

But not too much or key benchmark rates tied to mortgages, credit cards, and other aspects of business and consumer lending will overshoot. As always, Bernanke is playing a dangerous game here. The grain markets' surge are a shining example of predicting future stagflation.

NEW YORK (Dow Jones)--Introducing a penalty fee for failed transactions in the $5 trillion Treasury securities repurchase market has been a huge step toward improving repo trading and could serve as a template for future reforms.

Charging for failed transactions has significantly improved market liquidity and established a practical working model for future industry-based solutions, said Tom Wipf of Morgan Stanley, who chairs the Treasury Market Practices Group, an industry body sponsored by the Federal Reserve Bank of New York.

The penalty charges came into effect on May 1 and are levied on participants who fail to return borrowed Treasurys on time.

Since then, the number of fails in the Treasury repo market has fallen significantly, Wipf noted. That trend was already in place ahead of the May 1 launch date, according to data published by the New York Fed. Total repo fails stood at $79 billion as of April 29, from a peak of more than $2.7 trillion in October. That was when many repo market participants were unwilling or unable to return the securities borrowed amid the general market panic after the bankruptcy of Lehman Brothers.
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