One of the analysts I have started following is Harvey Organ, who follows gold and silver on the COMEX along with other kinds of trading action in related markets (no wheat or lumber, sorry). I started watching the gold/silver delivery issues but today’s action on in the Treasury markets is worth looking at.

Sez Harvey:

I would like to point out that during Sept and the first week of October, the 30 yr bond reached a price of 134.00 as the Fed announced that they were going to purchase the long bond hoping to help the housing industry. It seems that this has no failed.

The street does not want to talk about the other important feature of a fall in long bond prices and this is the huge derivative losses that are burning inside AIG and JPMorgan tonight. I am going to be very simplistic on this. If you feel up to it, I urge you to see Kirby’s paper ” The Elephant in the Room” for a complete and thorough analysis of interest rate swaps and what it means.

Here goes;

JPMorgan is by far the largest derivative player in the world and they are the largest player in interest rate derivatives. Most of these are in the field of interest rate swaps .In simple terms, our hero JPMorgan, on orders from the Fed buys a trillions of dollars of long bonds in the future and at the same time sells or shorts trillions of dollars of short term money of say 30 days or 90 days also in the future. The long bond was purchased at say a yield of3.4% to 4% and the short term money was shorted at a yield of .05% per annum or roughly par.

The huge purchases of these swaps (buy long term bonds in the future and short 90 day treasuries in the future) lowers the price of real treasury bonds as this stimulates the purchase of these bonds at the present time. This is why the bond vigilantes were nowhere to be seen in the states. It will also explain why our camp knew it was impossible for interest rates to rise as this would blow up JPMorgan.

Now we see that the long bond yield is rising which is putting much pressure as losses mount on JPMorgan. They gain nothing from the short end as they shorted at 100 cents on the dollar and that is today’s price.

The real risk to JPMorgan is the speed of which long bond yields rise as they cannot get out of their contracts. This will probably be the spark that ignites inside a coal mine. A yield of say 5% would create a 1.6% loss of over 640 billion dollars (they state, I believe, a notional 90 trillion interest rate swaps so 45 trillion on the long end and 45 trillion on the short end). That would blow up JPMorgan and create havoc and collateral damage equal to a neutron bomb in the financial area of Wall Street.

I hope this explains in simple terms how significant this is and I will now report on this as the bond yields have been rising exponentially these past few days.

For those of you who are mathematically inclined, I urge you to read Kirby’s paper and you will come to same conclusion as we have on the huge “elephant in the room” ie.

JPMorgan’s huge interest rate swaps. So JPMorgan not only has a silver problem but an interest rate problem!!

The ‘Kirby paper’ referred to is Rob Kirby’s analysis of interest rate swaps found on the estimable Jim Puplava’s Financial Sense website.

While these swaps are created and traded in the dark underbelly of the shadow banking system they serve the purpose of keeping a floor under long treasury prices … so far.

Uh oh … so far? The swaps become dangerous when the market ignores the message the swaps are preaching and moves so quickly and the swap positions cannot be unwound! As usual, the problem is leverage: JPM is massively leveraged in the synthetic market. The faster and farther the underlying Treasury market moves the farther underwater JPM becomes. In a way, Morgan’s approach is similar to the Long Term Capital Management’s failed arbitrage strategy of the late 1990’s.

Here’s the 30 year Treasury futures chart from estimable TFC charts:

Ouch! Here’s a look @ the rout in the 10 year. This tranche has been actively bought by the Fed as part of the fast becoming controversial Quantitative Easing ‘policy’:

Kirby notes that the five Too Big To Fail banks make the bulk of the interest rate swaps. Question is, when JPM or Citi blow up and lose another trillion will the taxpayer be called upon to bail them out AGAIN?

There is a real problem in the bond markets developing right under everyone’s noses. Add $90 oil and finance runs out of maneuvering room. Why the bond pressure?

• Too much debt is being dumped onto the markets. There is insufficient organic demand for this much debt. Productive enterprises have been replace by (debt) ponzi schemes. The debt market is saturated.
• Too much uncertainty about even the strongest economies. German has been having difficulties selling its bonds (!). Now, America?
• The risk is not inflation but the ability of markets to absorb the flood of new bonds.
• US states are in the cross hairs. Anyone who thinks Illinois or California are ‘credit- worthy’ is smoking crack.
• Obama is breaking his arm patting his back over his capitulation to the Republicans in the Senate … while the bond market is voting with its feet. Neither Obama nor Bernanke’s performance last Sunday instill confidence in American leadership.
• Meanwhile the Eurozone leadership is exposed as callow and self- defeating. The world’s major countries’ statesmen are failing. 

What would trigger the avalanche is the failure of a large institution that cannot or will not be bailed out. What is happening now is similar to what took place over the Summer of 2008: rising oil prices and derivatives pressures on systemically important institutions. Then: Fannie, Freddie, AIG and Lehman. Now: Citi, California, Spain and J.P. Morgan- Chase. Like 2008, the high oil price risk was spilling over into every vulnerable market, stress- testing every susceptible market participant.

The difference in 2008 was that the Fed and Treasury both had plenty of ‘ammunition’ and goodwill to put to use.

Now?

???