How central banking breaks down

People who work at trading desks in big banks are smart predators. They were trained to spot opportunities. An obvious opportunity is when a client gives an order that will move the market up, given this opportunity, the trader can buy some of the same stuff in advance, then sell after the price spikes. This is called front running and is, in this trivial form, illegal in most jurisdictions.

Front running the central bank

There are front running opportunities that are entirely legal and can be executed at huge scale. Perhaps the mother of all front running opportunities is the so called Quantitative Easing (QE). QE is just a fancy name for the central bank buying securities in giant therefore market moving quantities. They have been buying treasury bonds till now. In anticipation of a coming restart of QE nothing seemed more obvious in 2019 than front running the central bank by buying treasuries before they do, and that is exactly what trader did at huge scale. This is observable through rising treasury prices, falling yields.

The repo market

Holding a bag of treasury bonds in anticipation of coming QE drains cash reserves, but is not usually a problem as there is a so called repo-market. Repo stands for repurchase agreement and works a bit like a mortgage loan, but that the collateral of the loan is not real estate but a treasury bond. Should a bank temporarily need more cash it can enter a repo trade with someone else whereby the other lends cash and this bank pledges the treasury bond as collateral for the loan. Most repo deals are rather short term a few days or even just over night. Since the loan is fully collateralized the interest rate is usually low. This makes it usually favorable to enter a repo deal instead of selling the speculative bond position to satisfy short term cash needs. Remember the treasury bond position was acquired in anticipation of huge profits when QE happens, it was a shame if it was liquidated before that at loss, just because of some cash shortage.

The repo market works best if there are others with offsetting needs, that is some with surplus cash. Unfortunately that is not the case now as front running the forth QE after having seen how lucrative the previous three were for those with treasury positions is a too obvious trade. Every bank is short cash and long treasuries, they are all front running the central bank.

Temporarily running out of cash would mean failing payments, something a bank can not allow to happen, therefore they turn for cash to the lender of last resort.

Lender of last resort

The central bank is never short of cash, since it creates it. Therefore it is always able to offer repo deals at any magnitude. That is what the FED engages in increasing hundreds of billions since September 2019. Doing so however sends a signal to the market, that there is not enough cash for everyone. This is like blood in the water for the predators who have thereby the confirmation that some banks struggle and either have to pay high interest rate for short term cash or liquidate their bag of treasuries at depressed prices. Both are great opportunities for those who have good standing at the moment.

Who folds next?

The FED hoped that the repo market will return to normal after some help in September, but it has not. We are witnessing a stand-off between the central bank and big banks, which could play out in two ways, none pretty:

• Some banks might fret and sell their oversize bag of treasuries and cause a spike in treasury yields, which would freak out others since their bags would be losing and would lead to a crash of the bond market and soon thereafter the economy or
• The central bank could fold and buy treasuries thereby yet again enrich those front running its operation.

The second outcome could be less noisy for now, but bodes well for a repeat of the same problem at a higher magnitude with coming QE. The predators will be only more greedy by then.

What else?

The central bank might choose to buy some other assets this time to spoil the front running bets and still inject cash into the system. Inevitably its choices will be depleted and front runner of QEn will break the system.