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In yesterday's article I discussed the issue that the Federal Reserve may be anticipating a surge in inflationary pressures that may not present as of yet. The problem, as was seen in both in 1999 and 2007, is that when the Federal Reserve begins to raise interest rates, particularly in a low volatility and perceived "no risk" environment, bad things tend to happen.

(click to enlarge)

This is an issue that simply cannot be lost on the Federal Reserve. However, if that is the case then the question becomes-- what is potentially concerning the Fed enough that they are willing to risk sparking a market reversion? Barclay's Joe Abate provided a possible answer.

"Delivery fails in the Treasury market have surged recently. On Monday, the DTCC reported that incomplete deliveries reached a 52-week high at $120bn. And a week earlier, Treasury fails - as measured by the Federal Reserve - exceeded 6% of daily dealer Treasury transactions volumes. In effect, the securities lending program is a backstop source of specific issue supply that dealers can access temporarily to prevent market disruptions caused by fails or incomplete deliveries.

But what if the Fed does not own any of the issues that dealers need? Indeed, this appears to be driving the surge in recent fails, which have been concentrated in the OTR 5s and 10s. Operation Twist, and the sale of all the Fed's <3y paper has meant that the Fed does not own any securities that mature until early 2016. Without maturing paper, the Fed is unable to buy OTR issues at Treasury auctions. The fact that the OTR issues are trading special in the repo market also means that the Fed avoids buying these securities in its (diminishing) QE purchases.

In the absence of Fed supply, dealers face a choice: fail and pay a 300bp fee for not completing the promised delivery or offer a sufficiently low financing rate to coax supply of the issue back into the market. In effect, the 300bp fails charge becomes the threshold determining how rich an issue will trade in the repo market or whether it will fail.

But why do I care about some archaic money-market malarkey?Simple, Without collateral to fund repo, there is no repo; without repo, there is no leveraged positioning in financial markets; without leverage and the constant hypothecation there is nothing to maintain the stock market's exuberance.

The spike in 'fails to deliver' highlights a major growing problem in the repo markets that provide that leverage... and thus the glue that holds stock markets together."

This goes a long way to explain why the Federal Reserve has been so vocal about trying to coax bond holders to sell their bonds on the basis that rates are likely to increase sooner rather than later. Since the Fed's own policy of suppressing interest rates has forced investors to chase yield, the bulk of the supply of short dated maturities is being held for income and safety.

This is why the Fed is becoming concerned about the levels of collateral on the short-end of the interest rate curve as that is what supports both the repo needs and bank liquidity issues. The problem for the Fed is that their continued chatter about "raising interest rates" in an overly exuberant market environment spooks investors and pushes them into bonds for safety. This is exactly the opposite of what the Fed wants and exacerbates their problem.

The Fed's problem is two-fold; a lack of short-duration collateral and the inability to sell the assets they currently hold. The later point was recently discussed when Adam Taggart from Peak Prosperity interviewed Axel Merk, founder and CIO of Merk Funds who stated:

"If you're not concerned, you're not paying attention

What's driving the excessive complacency is today's markets is monetary policy. One of the main goals of monetary policy has been to reduce the risk premium; to make it less expensive for risky borrowers to borrow money. The reduction in the risk premium is what reduces volatility, and of course that spills over to other assets. We see that in the equity markets, the currency markets -- we see it everywhere. And volatility is compressed as well.

Janet Yellen was asked about this just a few days ago and she pretty much said how she is not concerned about complacency in the market. She is complacent about complacency. To me that is about as significant as Greenspan suggesting houses can never go down, and Bernanke suggesting subprime loans were contained. It is a major, major problem.

The Fed has bought all these assets by creating money out of thin air and now they are stuck with these. If they were to sell them (it is much easier to buy securities than to sell them), prices would plunge and, more importantly, the Fed would sell these assets at a loss.

Now, the capital base and the equity of the Fed is very small. Odds are that the losses would wipe out the equity at the Fed."

The ever present problem for the Federal Reserve is the conundrum of supporting asset prices as the underlying economy remains very weak. Despite the yearly disappointment that "economic growth" would attain "escape velocity," the markets have continued to push higher due to the enormous amount of liquidity pushed into the system.

Now the Fed's biggest risk has come home to roost. There is a limit to how many bonds the Federal Reserve can monetize before there is an imbalance in the credit markets. It is likely that we are nearing that limit. With very little margin currently between expansion and contraction in the economy, the Fed must be extremely cautious. Their "hope" is that they can keep the markets elevated through "forward guidance" as they try and slowly extract their liquidity support. So far, this "parlor trick" has worked by diverting the markets attention away from a litany of geopolitical and economic risks. However, the reality is that there is a large detachment by the financial markets from the underlying economic fundamentals. This was recently confirmed by the Bank of International Settlements:

"... it is hard to avoid the sense of a puzzling disconnect between the markets' buoyancy and underlying economic developments globally.... Despite the euphoria in financial markets, investment remains weak. Instead of adding to productive capacity, large firms prefer to buy back shares or engage in mergers and acquisitions.

As history reminds us, there is little appetite for taking a long-term view. Few are ready to curb financial booms that make everyone feel illusively richer. Or to hold back on quick fixes for output slowdowns, even if such measures threaten to add fuel to unsustainable financial booms. Or to address balance sheet problems head-on during a bust when seemingly easier policies are on offer. The temptation to go for shortcuts is simply too strong, even if these shortcuts lead nowhere in the end."

It is becoming quite apparent that the Fed is now fighting an uphill battle. While the majority of mainstream analysts and economists have bought into the ever evolving "economic recovery" meme, there is little evidence that such a recovery is in the works. While I have repeatedly warned of the rising risks of a market reversion in the past, Axel Merk summed it up well:

"Obviously, there are plenty of challenges in the world. Usually what tips a market over, though, isn't the most obvious thing because that's already "priced in". As a result, nearly anything can tip this market over. Suddenly one day people wake up, and the glass is half empty, and everybody runs for the hills."

Source: The Fed Needs You To Sell Your Bonds