"TGR: If we are in the final innings of a debt super-cycle, what is the catalyst that will end the game?
DS: I think the likely catalyst is a breakdown of the U.S. government bond market. It is the heart of the fixed income market and, therefore, the world's financial market.
Because of Fed management and interest-rate pegging, the market is artificially medicated. All of the rates and spreads are unreal. The yield curve is not market driven. Supply and demand for savings and investment, future inflation risk discounts by investors—none of these free market forces matter. The price of money is dictated by the Fed, and Wall Street merely attempts to front-run its next move.
As long as the hedge fund traders and fast-money boys believe the Fed can keep everything pegged, we may limp along. The minute they lose confidence, they will unwind their trades.
On the margin, nobody owns the Treasury bond; you rent it. Trillions of treasury paper is funded on repo: You buy $100 million (M) in Treasuries and immediately put them up as collateral for overnight borrowings of $98M. Traders can capture the spread as long as the price of the bond is stable or rising, as it has been for the last year or two. If the bond drops 2%, the spread has been wiped out.
If that happens, the massive repo structures—that is, debt owned by still more debt—will start to unwind and create a panic in the Treasury market. People will realize the emperor is naked."
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All it takes is a sudden 2% jump in interest rates. That will cause bond prices to drop, and because of leverage, the changes are multiplied.
What is the difference between 1.01 x 1.01 x 1.01 x 1.01 and .99 x .99 x .99 x .99? 1.04 - 0.96 = 0.08. Leverage is a double edged sword. You can lever up to make more money, but when it turns, you will lose much more quickly as well.
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