This is How a Financial Meltdown Might Be Starting

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Treasury Put Prices

Treasury Put Prices (volume added by Zerohedge. Published here with permission of Tyler Durden and Zerohedge.com)

Yesterday, according to CME data, Treasury futures put volume hit 758,020 contracts (second only to that 2007 high) as 74% of the entire options trading volume was in puts (and 88% of 5Y futures options were puts!). With the FOMC tomorrow and everyone seemingly convinced that the ‘great rotation’ is in place, it would appear the crowded trade is being bearish bonds.

This is how a financial meltdown might be starting. Buyers suddenly decide U.S. Treasury securities may not be risk-free any more.  They start to hedge against possible price decreases.  An easy way to do that and limit risk is by purchasing put contracts on Treasuries.  (A put contract gives the owner the right to sell a specified quantity of the underlying security at a specified price on or before a specified date.  Buying a put means the buyer is betting the price will fall, but still limiting risk to the price paid for the put.)

Today Zerohedge.com (@zerohedge aka Mr. Tyler Durden who will henceforth be called MR. Durden) pointed out that on January 28, the volume of puts on Treasury securities reached the second-highest level in history. From their story →

The Zerohedge analysis is that markets are anticipating the outcome of the FOMC meeting that begins today.  According to this analysis, the markets are anticipating that the Fed will announce they are beginning to unwind their balance sheet. That would cause interest rates to rise and Treasury security prices to fall. (If you don’t understand why that happens, either post a comment or e-mail me and I’ll put together an explanation.)

That analysis focuses exclusively on the supply side of the market.  Economists get paid to also consider demand side explanations.  The demand based explanation is far more frightening.  The prospect of investors avoiding Treasury securities because of an increase in perceived default risk should scare everyone, not just us paranoid economists.