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Thread: OK financial insiders, what gives with this ...

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    Banned Melonie's Avatar
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    Default OK financial insiders, what gives with this ...

    "U.S. Treasury Sees `Market Dislocation' in 2012 Notes (Update4)

    Sept. 14 (Bloomberg) -- The U.S. Treasury, concerned about a possible ``market dislocation'' in the 4 3/8 percent note due in August 2012, ordered any firm holding more than $2 billion of the security to report their positions.

    The Treasury, one of the regulators in the $4.1 trillion market for U.S. government debt, wants to avoid any disruption that may occur because one investor holds too many notes. Traders are willing to risk losing money to obtain the security because it is the cheapest that can be used to fulfill the $36 billion of futures contracts that come due on Sept. 30.

    The request was prompted by an increase in the number of firms that borrowed the note and failed to return it, said a Treasury official who briefed reporters on the condition of anonymity. The last time there was concern about a shortage of Treasuries eligible to settle futures contracts was in June when a record $14.2 billion of notes were used to meet the obligations.

    ``This is a warning shot in people's foreheads, that if there's a squeeze this time, recess is over,'' said Howard Simons, a Chicago-based strategist at Bianco Research LLC. ``They are saying, `if we think you've done anything questionable, we are going to yell and scream your name all over the place.'''

    This is the first time the government asked for ``large position reports,'' said a Treasury official who spoke on the condition of anonymity. The reports are due Sept. 20 for positions held at the close of business on Sept. 12, the Treasury said"

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    Veteran Member Lurker's Avatar
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    Default Re: OK financial insiders, what gives with this ...

    Bond futures (which are used extensively by lots of market participants to hedge interest rate risks) are priced based off the prospective future delivery of US Treasury notes or bonds. Most users of the derivative product (the futures) don't ever intend to own or deliver the actual notes, so they "cover" or "roll" their positions as the actual date for delivery approaches.

    However, the relevant price for the futures contract differs depending on WHICH bond is going to be delivered (prospectively) to fulfill the contract. At any given point in time, a single bond issue is the "Cheapest to Deliver", or CTD.

    The problem is that the CTD bond issue might only be 1/4 the size of the actual outstanding amount of bond futures for any given settlement date, so the whole market is being priced based on a scarce underlying commodity. This makes it susceptible to "squeezing", where a few large buyers buy the underlying bonds and hold the futures contracts into the delivery period rather than closing out their position. This forces people who have sold the futures contract to pay a premium for the cash bonds (relative to a theoretically "fair" price) to deliver to satisfy their contract obligations.

    It's a flaw in the market mechanism--far more people want to hedge or trade interest rate risk than necessarily want to be involved in the underlying securities. This leaves it prone to market manipulation--hence the Treasury stepping in to monitor trading to ensure that the futures market is allowed to continue to function smoothly as a hedging and risk management tool for financial institutions.
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  3. #3
    AudreyLeigh
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    Default Re: OK financial insiders, what gives with this ...

    What does all this mean in laymans (sp?) terms? I read it but dont understand it...

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    Banned Melonie's Avatar
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    Default Re: OK financial insiders, what gives with this ...

    Strategically, I think it means that the big financial institutions are now convinced that inflation and rising interest rates are the direction the US economy is clearly headed in, such that they don't want to continue to hold long bonds (which drop in value as prevailing interest rates rise).

    Instead, they buy and sell bond futures contracts which are basically promises to deliver a particular bond (or bond type) at a particular price at a particular future date. However, it appears we have reached the point that there are more promised bond deliveries coming due than there are bonds to deliver, as well as few counterparties who are agreeable to extending the futures contracts for another month. Thus some contract holders are potentially being forced to pay 'extortion' prices in order to come up with bonds they promised to deliver but don't actually own (i.e. they are 'short').

    Conspiracy theory wise, there is lots of speculation ... all of it pointing towards bad news for the US economy.

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    God/dess montythegeek's Avatar
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    Default Re: OK financial insiders, what gives with this ...

    To state what Lurker said in ordinary english, there are two items which have a mismatch. You can trade a security or you can trade a futures contract in a security. The number of open positions in the futures contract is not lined up to the number of real bonds coming due on that date, hence when the positions come close to having to be physically delivered someone is gonna get burned.

    Melonie is wrong about what is behind it. It is not a commentary about anything, but an oddity. A similar mismatch could occur if people wanted to trade gasoline contracts for October delivery so much that the amount they wanted to trade was a lot more gasoline than could be delivered.

    It could be large positions by a Fannie Mae or Freddie Mac hedging 15 year mortgages or adjustables and the underlying market is not big enough to support this hedging activity without weird stupid price moves which warp the market. My guess is someone forgot to look at if the market could support the trades before they executed some auto-pilot scheme to hedge. If a 7-year position is weird, it spills over and makes 10-year positions move weird. That makes new mortgage issues act weird for awhile and affects real activity in housing.

    A similar distortion could occur if someone trading for China, a major insurance company, or a merger screwed up. An example of the later is if Company A is buying Co. B and B has debt due 8/12 and A wanted to make sure the debt was hedged and put all there bests on the 8/12 instead of some 6/12, some 7/12. some 8/12 and some 9/12 etc. The amount of real debt dated 8/12 could also be goofy because someone at Treaury screwed up and did not keep the turnover amounts smooth when the Treasury was running a surplus (or since).

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    Banned Melonie's Avatar
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    Default Re: OK financial insiders, what gives with this ...

    At the very least, it's a commentary on a financial system that is based on promises instead of on the real article. You can't put gasoline futures contracts in your car's gas tank. This same 'flaw in the system' which created a short squeeze on bonds could just as well create a short squeeze on gasoline or any other commodity for which futures contracts are traded. However, the short squeeze on bonds doesn't directly affect Joe Sixpack since he doesn't typically buy/own bonds. Gasoline would be another story altogether.

    More on topic, some would argue that this peculiar bond futures action is indicative of big changes in direction by the financial powerhouses - and specifically an indicator that the financial powerhouses now are of the opinion that increasing inflation and rising interest rates are the future direction for the US economy.
    ~
    Last edited by Melonie; 09-16-2005 at 02:54 AM.

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    Veteran Member Lurker's Avatar
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    Default Re: OK financial insiders, what gives with this ...

    It's certainly a quirky aspect of the system--the problem is that the desire to trade something generic (futures) outweighs the desire to trade any of the specific underlying securities (for operational reasons as much as anything--all successful futures contracts are generally nicely tailored to provide liquidity to market participants beyond what they could get in the relevant cash or over-the-counter forward markets).

    But it's not really reflecting any overarching view by big financial institutions. The two firms which are under the most suspicion are just big investment management firms. They saw an opportunity to squeeze the market and make a little money--nothing more. If you want to get a read on what the "financial powerhouses" think about interest rates, you can just look at the 10-year US Treasury rate--you don't really need to delve into arbitrage strategies like this one.
    "All this time you were pretending
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