The economy was sailing along into its Hollywood sunset in 2014 before it was rudely interrupted by the “rising dollar.” At first, the mainstream narrative was that a higher dollar exchange was a good thing, an indication that global markets were embracing the economic revival; or, if you didn’t quite want to get that optimistic, it at least signaled the US as the cleanest dirty shirt.

Nobody thinks that way anymore, at least where the “dollar” is concerned. The latest set of GDP benchmark revisions is a good enough demonstration of the considerable negative force associated with that currency regime.

The “rising dollar” didn’t come out of nowhere, no matter how many times in 2014, 2015, and 2016 economic weakness was declared “unexpected.” The warning signs were all dismissed as either mixed up signals or something altogether different from what they were. One of the most prominent of those alarms was the sudden spike in repo fails at the end of Q2 2014.

Repo fails can be interpreted as some measure of desperation for bond market shorts. After all, if you expect the recovery scenario to come true, why not go short UST’s because, pace Alan Greenspan every year, interest rates would have nowhere to go but up and would do so quickly. If there are a lot of shorts, then that side becomes crowded and covering them can become difficult at times. Repo fails look a lot like a short squeeze.

This is exactly how that burst of failures in 2014 was characterized. It was comforting in a way, because the shorts explanation was actually consistent with the recovery narrative. The more it looked like the Fed was right about QE3 (and 4), the more UST participants would want to short UST’s, so many perhaps that they all crowded in too fast to put their (borrowed) money where Janet Yellen’s mouth was.

As one BofAML analyst described in this FT Alphaville article from early July 2014:

In the past month various issues across the US Treasury curve have traded special in the repo market, indicating that the demand to borrow the securities from shorts has increased relative to the supply of bonds being lent by longs. In our view, analyzing the causes of the recent repo specialness and the associated increase in settlement fails reveals information about Treasury market conditions that is relevant to investors more broadly. In particular, we believe increased specialness could be symptomatic of lingering fast money shorts and sizable central bank buying, as well as regulatory constraints on dealers’ ability to intermediate in the repo market.

The indispensable Izabella Kaminska, the author of the piece, instead flushed out the greater or higher order factors to really consider (or reconsider, if your tendency was to blame shorts).

So here’s the thing. Yes, in the context of the wider fails problem of 2008 the recent June spike looks insignificant. But another way to think about this is that the fails are happening despite the presence of the 3 per cent fails charge and despite the presence of the Fed’s new Reverse Repo Facility, which should also have eased pressure in the market. [emphasis in original]

Shorts or not, the fact that repo fails were happening and to such a degree was what really mattered. Eliminating the happy narrative was simply a matter of realizing that nobody sensible would really need to be short cash UST’s when Treasury futures would provide a much better platform. There is now, and was then, far more liquidity in Treasury futures as well as an obviated need to participate painfully in any short squeeze of any size and duration.

As Izabella concluded, “To us that suggests the financial plumbing of the system will become a key concern of the Fed…” If there is one word in that sentence that was noticeably inaccurate, it would have been more precise to have written it “should become a key concern of the Fed” because it never did. Even after the buying panic on October 15, 2014, which was in every way related to repo fails and collateral difficulties, officials refused anything but to sit idle.

Why they did so will have to remain a matter of private discussion, at least until the transcripts for that year are released in early 2020. I believe it easy to surmise their reluctance, for policymakers who were so very invested in the recovery scenario which carried with it the burden of, in Janet Yellen’s words, financial system “resilience”, that to admit there was a serious shouldn’t-be-happening collateral malformation in vital repo markets would threaten to spoil the whole thing.

So they preferred instead to cross their fingers and hope “the shorts” was really the right explanation – all the way until 2016 when by then the party wasn’t just spoiled, it was shut down permanently.

In addition to Izabella’s contribution, there was another angle to consider perhaps equally important. I wrote a week after her:

As I said in my last post on repo, the fact that there is a fragility evident in the second week of June in both 2014 and 2013 (in addition to major liquidity events, related to repo, in the second week of September in 2007, 2008 and 2011, not to mention 1998) is a major warning about systemic bottlenecks. The very real fact of quarter end maneuvers is like the tide washing out and revealing a lot of naked swimmers. Unfortunately, the prevalence of nudity (extremes in risky positioning) is hidden the rest of the time which most participants take as simple “normalcy.”

These regular seasonal ebb points have had the effect of illuminating previously hidden weaknesses. We have witnessed time and again the regularity of liquidity problems timed to whatever seasonal factor (such as CNH in offshore China, meaning Hong Kong, that only for each of the past two years ahead of both semi-annual Golden Week celebrations).

It easy to dismiss all this stuff as mere noise; markets are always messy and there has always been something throughout history to nitpick. But these are not your usual nits to pick, and they haven’t been for just about ten years now. Izabella was right that repo fails with a 3% penalty in addition to the RRP shouldn’t ever be much of an issue. But they were then, and are still now.