Lessons from a bond market insider

One of the most intriguing players in the Watergate scandals that mesmerized the US from 1972-74 was nicknamed “Deep Throat” after the title of a popular adult film of the time.

One of the most intriguing players in the Watergate scandals that mesmerized the US from 1972-74 was nicknamed “Deep Throat” after the title of a popular adult film of the time.

Deep Throat was an anonymous source who provided important clues to Bob Woodward and Carl Bernstein, reporters for The Washington Post that helped them unravel the web of burglary, dirty tricks, payoffs, perjury and cover-ups emanating from the Nixon White House.

These illegal activities all fell under the heading of “Watergate,” a political scandal that led finally to the resignation of Richard Nixon as president.

The identity of Deep Throat was one of the best-kept secrets of the 20th century. It was only in 2005, over 30 years after the Watergate scandal broke, that Deep Throat was revealed to be W. Mark Felt, the deputy director of the FBI at the time.

Given the sensitivity of Felt’s position, and the journalistic ethic that requires protection of sources, it is perhaps not surprising that Deep Throat’s identity was so well hidden for so long.

The value of protecting your sources

But reporters are not the only ones who need to shield the identities of valued sources. Sensitive issues arise all the time in economic policy and geopolitics. Principals may be willing to share information with trusted associates, but only if their names are not revealed.

This kind of cooperation preserves access to information in the future and provides a valuable service to readers if the information can be shared.

This point was brought home in a recent article in The New York Times in which Arvind Subramanian, chief economic adviser to the government of India, while referring to US economic weakness said, “People can’t be too public about these things.”

I recently had dinner in my hometown of Darien, Connecticut, with one of the best sources on the inner workings of the US Treasury bond market. Our dinner took place at the Ten Twenty Post bistro, the same restaurant I wrote about in my first book, Currency Wars.

It was there that a friend and I invented the scenario involving a Russian and Chinese gold-backed currency that we played out in the Pentagon-sponsored financial war game described in that book.

Now I had returned for another private conversation with another friend. But this time we were not discussing fictional scenarios for a war game. The conversation involved real threats to real markets happening in real-time.

I can’t reveal the identity of my dinner companion, but suffice it to say he is a senior official of one of the largest banks in the world and has over 30 years’ experience on the front lines of bond markets.

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He has been a regular participant in the work of the Treasury Borrowing Advisory Committee, a private group that meets behind closed doors with Federal Reserve and US Treasury officials to discuss supply and demand in the market for Treasury securities and to plan upcoming auctions to make sure markets are not taken by surprise.

He’s an insider’s insider who speaks regularly with major bond buyers in China, Japan and the big US funds like PIMCO and BlackRock. For purposes of this article, let’s just call him “Mr. Bond.”

Over white wine and oysters, I told Mr. Bond about my view of systemic risk in global capital markets. In effect, I was using Bond as a reality check on my own analysis.

First, develop a thesis with the best information available. Then test the thesis against new information every chance you get. You’ll soon know if you’re on the right track or need to revise your thinking. My conversation with Mr. Bond was the perfect chance to update my thesis.

I told Bond that markets appeared to be in a highly paradoxical situation. On the one hand, I had never seen so much liquidity.

Literally trillions of dollars of cash were sloshing around the world banking system in the form of excess reserves on deposit at central banks — the result of massive money printing since 2008.

On the other hand, something was definitely wrong with liquidity. The Oct. 15, 2014, “flash crash” of rates in the Treasury bond market was a case in point.

A freak move in the bond market

On that day, the yield on the 10-year US Treasury note fell 0.34% in a matter of minutes. This is a market in which a change of 0.05% in a single day is considered a big move.

The Oct. 15 flash crash was the second most volatile day in over 50 years. Something was strange when there was massive liquidity in cash and complete illiquidity in notes at the same time.

Here’s a chart showing the bond market flash crash on a minute-by-minute basis. The time of day is along the horizontal axis and the yield-to-maturity is on the vertical axis.

You can see how yields crashed from 2.2% to 1.86% between 7:00 a.m. and 9:45 a.m., with most of that crash taking place in just a few minutes between 9:30 and 9:45, just after the stock market opened.

Almost no one alive today in the bond market had ever seen anything like this.

In Part 2 I’ll give you the behind-the-scenes scoop on why this sudden move in bond yields was even scarier than I first thought.

Jim Rickards

For The Daily Reckoning

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