HOLY SH*T! Banks Are Preparing for Something Big

0:00 Something is going on in the financial system and now it's got dealers involved in it. I flagged the four-week Treasury bill over the last couple weeks, but that's just where this begins. Primary dealers have been piling into Treasury bills of all kinds. And they usually do this just before something is about to happen, something deflationary. Not every time, not in every case, but in more than enough cases that we need to take this very seriously. Just for an example, dealers piled into bills in February 2023, just before Silicon Valley Bank. And then they did the same thing last year in the weeks leading up to the carry trade blow up. In November, huge increase in bill holdings right before the dollar shortage spiked into the US dollar exchange value. And of course, dealers

0:47 were building up Treasury bills back in February prior to the March and April deflation liquidations. We also saw something happen last Thursday. the day when the four-week bill yield dropped as sharply as it did. That was the same day that we saw longerdated swap spreads like the 10 and 30-year maturities nearly hit record lows. There was even a noticeable dip in the 3-month Japanese government bill yield. As far as swap spreads, those haven't budged from their April lows. Some of the shorter data maturities like the 5-year retraced a little bit, yet the 10 and 30s remain at these extreme levels. So while stocks or at least some stocks are soaring back into the stratosphere, the actual marketplace in the monetary system doing something entirely different. The entire

1:34 world, especially interest rates, has been following the trajectory laid out by the swap market in particular over the last couple years. And that includes all the recent macroeconomic data which shows the consumer economy in the US, the labor market has indeed shifted and shifted dramatically. But the swap market picture also includes on the monetary side the potential for more deflationary outbreaks like we saw in April. And that includes collateral shortfalls and what might be bubbling up behind the scenes in the bill market. So as the second half of 2025 begins, we've got to pay attention to the swap market and what's happening in bills because swaps, they've been almost spot on, as close as spoton as you can get for decades now. Nothing is ever perfect,

2:21 but here in the 2020s, they've been particularly useful and valuable. And remember, the the swap market is the biggest in the world, and I would argue it's the most important, even though most people have never even heard of it. But then again, most people still haven't heard of the Euro dollar either. So there you go. Now, swaps told you back in 2021 and 2022 there was no inflation risk. That instead, the economy was going to fail to live up to the hype of recovery and eventually leave everyone behind. and impoverished by that supply shock, the phase shift in prices. It was the swap market that said forgot how to grow before the economy ever forgot how to do that. And swaps aren't really that difficult to understand either. They're pretty simple. Down meaning more negative is basically negative on the future. Up is

3:07 a little bit less pessimistic, maybe even more optimistic depending on how far up they actually go. The problem is they never get that far. And this is why for Eurodell University's webinar on July 10th, we're going to be focusing on the swap market and the curves because they are sending us big-time messages right now. After everything, including central banker policy changes, have moved exactly the way the swap market has been pricing this entire time. We really need to go deep into the current shape of the market and what it's really telling us in far more detail. And that's exactly what we're going to do for our webinar Thursday, July 10th at 6 p.m. There's a link in the description of this video to sign up. And we also have a Rio University anniversary sale for all of our subscriptions, including

3:53 our latest one that we're going to feature. Plus, I've got a special price for our deep dive analysis that covers everything. So, the webinar sign up and its details, those are in the link in the description of this video. More information about our subscriptions, that's at our website, eurodoll.university university. On the most basic and fundamental level, what swap spreads really tell us is where short-term interest rates are likely to go in the future. Since the floating rate side of an interest rate swap is tied to sofur, that's where we start and then we go from there into all the rest of the interest rates as well as trying to fill in the picture behind how the world would explain where interest rates might more likely are to end up going. So negative swap spreads are the market signaling that rates are likely to go lower over time from wherever they are

4:40 at the time. The more negative the spread, the lower short-term rates are likely to go and the more confident the market is for that outcome. And we're talking about longer data swap contracts like the 10 or 30-year maturities. If they're really negative and getting more so over time, that's the market saying with very serious confident that it believes rates are going to go down a lot and stay there for a long time. So, we have to ask ourselves, what are the potential scenarios that would lead to a future where rates go down and stay there? Well, to begin with, we just lived through it in the entirety of the 2010 silent depression. Low growth, really no growth, especially in the labor market. low inflation or really no inflation at all to speak of. Economic

5:25 circumstances that are more like a depression than not. That's what a long run future of low interest rates that stay there actually looks like. And over the last couple years here in the 2020s, as I mentioned, everything seems to be lining up again for that possibility. I mean, even central bankers are already on board, at least by and large. That's where the Pringles can analogy comes in or why I keep using that as a as a way to picture how once central bankers start cutting rates, once they pop the rate cuts, they can't ever stop. Even the Federal Reserve is going to be doing it here at some point. They're going to pick back up on their rate cuts because interest rates overall around the entire world are moving lower and they're moving decisively lower just like the swap market has been pricing for the

6:11 last couple years. Why? the forgot how to grow economy that the swap market warned about back in 2022 does seem to be remembering how to do worse. So on the macro side, the macro picture for where where we have negative swap spreads, we already see evidence here in the United States that the consumer economy has changed dramatically and I went over that in yesterday's video. And most people haven't heard the evidence or seen it because the stock market keeps hitting record highs or at least stock market indexes are. So, everyone has gone back to sleep on where the economy really comes into it. But the other part of swap spreads isn't strictly macroeconomic. There's the monetary side, the potential deflationary outbreaks that we've seen way too frequently over the last couple years.

6:57 That's where you see low interest rates as a product of flight to safety, higher demand for liquid instruments, a higher potential for more and more serious deflationary developments like we've seen in APO, for example. And those deflationary developments, they very much include potential collateral breakdowns, interruptions in the flow of collateral, and potentially leading to a shortfall, some scarcity, and if in the worst cases, maybe even a shortage. Now, what I've shown you so far over the last couple weeks, including in the video I did with Steve on Sunday, is that the four-week bill yield has been falling more than we would expect given the debt ceiling. It started back on June 5th thereabouts. And these these dates I'm giving you are Thursdays because that's the day when the Treasury Department

7:44 auctions off both four and 8week Treasury bills. So there's been a lot of action at the Treasury auction. So back on June 5th, the secondary market yield, so this is not even the auction price, was down to around 4.26% which is right above the reverse repo, which is supposed to be the floor. So, it's already well below the repo market, meaning that participants in the marketplace are choosing to buy treasury bills even though it yields them less than they can get in other places around the money markets. The next Thursday, the next auction in the secondary market, June 12th, the four-week treasury bill rate was down to 4.18%. And it was down 12 basis points from the day before. That's how much these auctions are making a difference. and 4.18%. That's seven basis points below the RRP,

8:30 which means these bill owners, these heavy bidders are buying bills for over and above what they could get in other places around the marketplace. They're giving up a lot of return in order to buy specifically bills. Then the following week on June 18th, which was a day ahead because of the Junth holiday, the yield was down to 4.2%. And then last Thursday on June 26th, the yield dropped to 4.11% in the secondary market. And at the auction itself, as I pointed out, it was all the way down to 4% flat, well below the RRP, well below repo. Now, you can explain some of the in some of the additional buying in four-week treasury bills because of the debt ceiling. We already we do see that parts

9:17 of the money market are moving away from the eightweek bill because of these fears that maybe the eightweek bill is going to come due in the middle of August and if the US government has exhausted all of its emergency provisions to to get around the debt ceiling there's no debt sealing deal at the time ve very tiny chance that the government misses a a coupon payment or in the case of a treasury bill misses a maturity money market funds will not take that chance they have been from the middle of June rolling out of the 8we week just in case that comes due at the wrong worst possible time and rolling some of their funds into the four-week instrument because that makes sense. The 8week and four-week bills are basically interchangeable. But as that happened, the 8week Treasury bill rate was going up and the four-week bill rate was going down. The four-week kept going lower and

10:04 lower and lower to the point, as I just mentioned, it couldn't have been all the role from the 8week. At some point, money market managers and other financial part counterparties would have chosen to roll into repo or some other safe alternative. They wouldn't just give up the return and just blindly buy four-week bills as the yield kept falling farther and farther. So, there had to have been more than just the debt ceiling involved with why the four-week bill yield was going down so much, why there was so much demand for that particular instrument. But here's the thing, it wasn't just the four-week bill auction. We also see a sharp drop in spreads in the swap market. In fact, the 10-year maturity very nearly hit a record low. Was it was within half a basis point of a record low. The 30-year maturity was a couple basis points above its record low. Both

10:51 of those on Thursday, too. And yes, the swap market is linked to collateral since swap trades and swap transactions are collateralized to some extent. And there are money dealers on the other side of almost every swap transaction that takes place. And just to show you how widespread these monetary mechanics can go, how about Japanese government bills, especially the three-month maturity there, which I've talked about many times before, and how cor how much there's a correspondence between behavior in the Japanese 3-month bill and the rest of these Euro dollar indications, especially where collateral comes in. There was a very clear correlation last July and August, really in August with the carry trade blow up for, you know, the the obvious Japanese participation in that. But we see this repeatedly throughout the last really

11:37 decade where the the Japanese three-month bill when we see extra demand for it, we know there's likely collateral problems in the US dollar system. So go back to the middle of June, the three-month bill yield in Japan is around 43 and a half basis points. This is about the high it's been. uh it's still well below the bank of Japan's overnight rate, but then it started to move downward. So that by Wednesday last week, the three-month Japanese bill is at 37 and a half basis points. So that's a six basis point move, which maybe it doesn't sound like much, but that's a big one for Japanese government bills. And it's more evidence that something has been going around going on around the Euro dollar system. It's not debt sealing. It's more monetary systemsp specific and zeroing in on collateral.

12:25 But the most compelling clue comes from the behavior of primary dealers. Now, I mean specifically primary dealers because that's the data that we get from the Federal Reserve Bank of New York. And if you're not familiar, primary dealers are the what is it 23 banks that have been approved by the Federal Reserve Bank of New York to do business with the Federal Reserve itself, usually through the open market desk at the New York branch. Now what we've seen throughout uh really the last 20 years is that dealer holdings of coupons meaning notes and bonds and treasuries they will rise during these euro dollar periods where we see deflationary conditions more broadly start to show up in things like swaps as well as the yield curves. And what we saw earlier this year is that dealer holdings of coupons, notes and bonds just absolutely exploded. That

13:12 started back at the end of November during the initial dollar crisis. the dollar shortage that we showed that showed up in December and January. But then the dealer stock of notes and bonds stayed high throughout the last couple months, especially through the deflationary episode in April. But we're not talking about notes and bonds here. We're going to focus specifically on bills because that's where we seem to get a lot of information as well as confirmation here about June and now heading into July 2025. Now, what happens is dealers tend to stock up on treasuries, whether notes, bonds, or bills, when they're seeing collateral difficulties in the future, either as a defensive measure to make sure that they have access to collateral that's already on their balance sheet for their own purposes, or as a profit opportunity, expecting that any

13:59 collateral shortfall and difficulties will lead to higher prices to rent out notes or bonds, whatever, to a more desperate marketplace. Now, with Bill Holdings, it's mainly the latter of those, a profit opportunity because dealers will see trouble coming. They buy up bills smelling collateral opportunity. They stack them up in the weeks leading up to the deflationary episodes and then sell and rent them off as the disorder and dysfunction starts to arrive and hit. That's exactly what we saw, for example, starting in the middle of January 2023. In the weeks and really couple months leading up to Silicon Valley Bank, dealer holdings of Treasury bills started out around 21 billion, which is a relatively low level the week of June of January 11, 2023. That had shot all the way up to 110 billion by the week of March 1st, which

14:47 is the week just before all the events with Silicon Valley Bank. And by the time we get to that week, dealers were already selling out their bills or likely renting out their bills the week of March 8th down to 103 billion. And over the next couple weeks, while the disruption, this order really started to develop and hit from Silicon Valley Bank on through the failure of credit Swiss, you see primary dealers holdings of Treasury bills decline all the way to 62.3 billion. But then they rebuilt them and they stacked more bills, got up to above 100 billion all over again the week of March 29th, anticipating that there was more trouble to come, which there was. And over the next month and a half or so, as that trouble continued to develop, they their holdings of treasury bills dwindled all the way down to about 27 billion by the week of May 10th,

15:34 which is just after everything finally ended. Now, I should point out again that not all these spikes in dealer holdings of treasury bills lead to some obvious deflationary outbreak. There are times when dealer holdings rise and maybe even rise sharply that maybe it's for benign technical reasons or it doesn't lead to the type of dysfunction and disorder that we we actually notice across the wider marketplace. However, this has happened way too much over the last couple years and more often than not it does lead to something that we eventually see in the wider system. Another example, last year, last summer, the carry trade blow up. Back in the middle of June, dealer holdings of Treasury bills were relatively small, around 39.3 billion. Over the next month

16:20 through July, as the carry trade reversal was building, as the US economic situation became more and more questionable, they had built their holdings up well above a hundred billion again as everything was coming to a head. And then the final week in July, as things began to happen, they were already selling and renting their bills out. And then the first couple weeks in August, they rebuilt their holdings of Treasury bills, reloading, expecting more difficulties around the monetary system still to come, which is exactly what happened. And then their bill holdings continued to fall through September, which is when we saw more open and more obvious signs of collateral collateral strain, especially the four-week bill yield that fell below even terms so far and other alternatives. But maybe the most explicit example, most explicit immediate example came in November of

17:05 last year, just before the dollar spike and the dollar difficulties back in December and January. From the week of October 30th, dealer bill holdings were around 33.9 billion. They moved up to 58 billion by November 20th. And then they soared the final week of November to 113.4 billion. If you remember, I talked about this back then. We went over the bill auctions and the surge in demand at those auctions, the huge bids that were coming in just as the dollar was beginning to explode higher into a mini currency crisis around the world. We saw foreign reserve managers selling their treasuries and mobilizing the reserve assets to try to deal with that dollar shortfall, forcing long-term treasury yields higher. It was a very clear dollar shortage and dealers were still building their inventories of

17:52 bills up to around 119 billion the week of December 18th. And then from there, as the as the disorder and dysfunction got worse and worse and worse, their bill inventories fell back to around 53.5 billion by the middle week of January 2025 when everything seemed to finally settle down. But it didn't actually settle down because then they started to build their inventories of bills all over again. So that by the end of February, they were holding more than 100 billion all over. And it stayed right around 100 billion through February and March as we got more and more volatility. So that once more we see they begin to sell out their treasury bill inventories or rent them out for whatever purposes as more and more obvious deflationary circumstances develop the entire financial system. By the first week of May dealers holdings

18:38 of treasury bills had dwindled down to around 36 billion. By a couple weeks later it was up to around 46.8 billion. So starting to stack some more bills. That's right when we see the inflection in the bond market and bond deals as well as you know something like the Swiss Frank. And then by the middle of June, which is the latest data that we have, the week of June 18th, inventories had skyrocketed again to more than 90 billion as we see the four-week bill come under pressure and not because of debt sealing reasons. So once again, we have primary dealers that are beginning to stack up Treasury bills. At the same time, we get all of these other indications from the swap market to the Treasury bill yield itself at the four-week maturity suggesting there is something going on under the surface.

19:24 So, we already have the background where swap spreads are highly negative and haven't changed. I've talked about the Swiss Frank and that one. We've already got macro confirmation for the swap background in the consumer economy. Therefore, weakness in the labor market and potentially meaning worse in the second half of this year. But on the monetary side, the collateral side, something is going on with Treasury bills, especially the four-week bill. And a little of that might be the debt ceiling, but not all of it. There is too much corroboration for something happening in the collateral markets. And a big one is dealers. In this situation with the data that we have and what's going on in the marketplace, it stands to reason that they can smell something. Smell something that will be profitable for them to stack up treasury bills if

20:11 collateral becomes more difficult in the weeks ahead and leads to higher treasury bill prices and higher treasury bill rentals. In other words, what swaps have been saying all along on the monetary side is a high chance or too high chance of more deflationary outbreaks, maybe more serious deflationary outbreaks. And now we see that dealers in the bill market and elsewhere are sensing the same thing. The swap market has said this is the direction the world is going and it has been pretty much spot-on over the couple years since then. And now the swap market is saying we need to be on the watch out for a lot of things that are happening in the macroeconomy, but also in the monetary system. We need to take this seriously because at the very least primary dealers already are.

20:59 None of this is to downplay the shift in the macro economy because that's really serious too. And I went over the details with the consumer spending and incomes in the video link below. As always, thank you very much for joining me. I hope you can join me on July 10th for our webinar. There's a link in the description to sign up. Huge thank you URL University members and subscribers. And until next time, take care.