As if the US Treasury market did not have enough things to worry about after Friday's sharp sell-off and steepening of the yield curve, ahead of today's 10Y auction there is another problem facing the bond markets: a fresh episode of substantial collateral scarcity, manifesting itself in another round of "near fails" repo rates for benchmark US paper.

As Stone McCarthy reports this morning, the 10-year note is trading at -270 basis points this morning, after trading at -270 basis points at the end of last week. Though issues often trade special, there is a limit to how low they can trade. Or rather, there should be. The dynamic fails charge is the rate paid by the party who fails to meet delivery for a repo transaction. The fails charge is either 0%, or 3% minus the lower end of the target fed funds rate (whichever is higher). With the low end of the target fed funds rate at 25 basis points right now, the fail rate is currently 275 basis points, which should serve as a floor for how low repo rates can go. Currently, it is serving as a floor for the 10-year note repo.

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As SMRA adds, with the 10-year note repo trading at -270 basis points this morning, we can expect a decent amount of volatility today. In March, the 10-year note did trade below the fails rate for nearly a week. Should it fall further from its current rate, even slightly, it will become less costly for a counterparty to fail to deliver 10-year notes than to try and obtain it through the repo market. This means fails, and fails on the 10-year note in particular, will likely see a noticeable jump, much like the one in March.

Ironically, it also means that as the Fed contemplates tightening the bond market with another rate hike, the most likely outcome would be to exacerbate the scarcity in the market even more, particularly if we get the traditional uber-flattening response to another Fed hike, driven by a puke in risk assets and a rush into "safer", long-dated bonds.

How the Fed will extricate itself from this latest predicament where it is damned if it hikes, and damned if it doesn't, remains to be seen. The good news is that the spike in 10Y negative repo rates, and thus collateral shortage, traditionaly only takes place ahead of the respective 10Y auction. If and when shortages extend well beyond the settlement date, that is when it will be time for Yellen to panic.