OMG! You Won’t Believe What Just Happened in the Treasury Market

The repo facility is experiencing a year-end surge in borrowing, significantly higher than anticipated. Repo fails, which indicate collateral scarcity, exploded in mid-December, signaling potential issues in the collateral market. The Treasury market is ending 2025 with significant shifts, largely driven by bill yields, which are reshaping the yield curve. The FOMC minutes from December align with these market signals, suggesting tighter money and flatter beverage curve, prompting the Fed to restart asset purchases (not QE) to increase bank reserves.

The year-end funding strain is more severe than normal seasonality, with the Fed restarting asset purchases to increase bank reserves. This 'not QE' approach aims to alleviate market strain. However, the video argues that bank reserves are not the core problem, as evidenced by significantly higher borrowings from the Fed's repo facility compared to previous years, even with similar reserve levels. The idea that bank reserves and Quantitative Tightening (QT) are solely to blame for market volatility is dismissed as a myth propagated by the Fed.

Repo fails have been rising since summer, accelerating after discouraging labor market reports in July and August. They reached 573 billion in mid-December, a level not seen since the 2022 collateral crisis and even surpassing March 2020 levels. While not indicative of a full-blown crisis, this surge points to serious disruptions in collateral flow, which directly impacts cash flow in the Eurodollar system. When collateral flow tightens, it creates scarcity, leading to a flight into top-tier collateral like Treasury bills.

A tightening in collateral flow leads to increased demand for Treasury bills, especially the four-week instrument. Historically, during acute shortages, the price of four-week bills surges, and their yields plunge. This was seen during Bear Stearns in 2008 and the banking crisis of March 2023. Recently, the four-week bill rate has seen a significant drop, suggesting collateral scarcity. Different sources provide varying yield figures due to the nature of bills not paying interest, but even the higher estimates indicate unusually low yields, hinting at a collateral premium.

The Fed's 'not QE' bill-buying program, while intended to help, may inadvertently contribute to artificial scarcity by removing bills from the marketplace, exacerbating pre-existing collateral tightness. Additionally, the FOMC's interest rate policy influences bill yields. Recent FOMC minutes reveal a shift in sentiment: fewer policymakers are advocating against rate cuts, and more are open to them in 2026. This dovish stance is driven by the absence of tariff inflation and growing concerns about labor market deterioration, moving the Fed closer to the market's 'flat beverage' view.

The uninversion process of the yield curve, which means it's steepening towards an upward slope, is in its final stages and has now reached the bills. While long-term rates from the two-year mark have remained remarkably stable for an entire quarter, they are resisting upward pressure from steepening due to concerns like collateral scarcity and fears of a 'flat beverage' economy. This delicate balance is expected to shift, with negative fundamentals eventually driving the entire curve lower. The year 2025 ends with a highly normal yield curve, a sign that the market has processed the Fed's policy actions and is facing significant economic challenges. The growing certainty around these economic and monetary difficulties suggests a challenging outlook.