F[ail]ed Auctions - Macro Market Dislocations and Volatility on Polymarket
When Central Banks Surrender to Market Forces
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We're entering a volatile period in markets where a perfect storm might be brewing - one that puts the reliability of Treasury auctions in question for the first time in decades. While it might sound alarmist to talk about "failed auctions," the warning signs are there if you know where to look. During periods like this, understanding these dislocations offers speculative opportunities, particularly in prediction markets like Polymarket where sentiment often lags reality.
Rate Cuts Off the Table
As equities rally and tariff risks ease, the forward curve confirms that a rate cut in June is practically zero probability. We just moved through the CPI, PPI, and retail sales data, leaving little to change the outcome of this meeting unless the world collapses.
Polymarket is pricing an 11% chance, which represents a small premium vs the actual market. Betting on this going to zero is a great way to make a small win. More importantly, the lack of rate cuts ties directly into our auction failure thesis - the Fed is stuck in a situation where inflation concerns prevent them from easing monetary policy exactly when the Treasury market needs support the most.
Recession Probability Overpriced
The lower probability of Fed cuts connects directly to the probability of a recession decreasing. Given the current macro backdrop, recession odds are likely to drop further. The odds of a US recession in 2025 are currently priced at 38%, which I expect to drop to 20% in the coming months.
This creates an interesting paradox - while economic data strength reduces recession odds and supports equity markets, this same strength keeps the Fed from cutting rates, exacerbating the Treasury auction problem. Strong economic data without Fed support means Treasury yields rise, potentially triggering the very market stress that could lead to auction failures.
Trade Resolution Plays
A significant portion of recent market volatility stems from tariff uncertainty, which should resolve in short order as we're already seeing progress with China. We're likely to see significant developments with European Union, Mexico, France, and Germany given their close connection with the US.
These resolution scenarios create tradable opportunities in prediction markets, where many contracts are still priced at coin flips. Going long on resolution before July offers excellent risk/reward. Additionally, if a deal happens with the European Union, France and Germany will naturally be included, creating spread opportunities by going long Germany and France while shorting European Union contracts.
The Growing Risk of Treasury Auction Failures
The idea of a Treasury auction failure sounds absurd to most market participants who've spent their careers in a world where US government debt is the bedrock of the financial system. But historical assumptions about "risk-free" assets get tested in times of excessive debt issuance and changing global dynamics.
Several indicators suggest we're approaching a danger zone:
First, recent Treasury auctions have shown volatile bid-to-cover ratios, with the most recent 10-year auction on April 9th delivering a 2.67 ratio - higher than expected, but masking underlying problems. The high participation of indirect bidders (over 87%) suggests excessive reliance on foreign buyers who may not always be as eager to participate, especially as global central banks diversify reserves away from dollars.
Second, the Treasury needs to finance a staggering deficit, with over $2 trillion in new debt issuance needed this year alone. This crushing supply comes at precisely the wrong time - when the Fed has been reducing its Treasury holdings and global investors are questioning the sustainability of US debt levels.
Third, we're seeing rising volatility in the Treasury market that resembles mini-versions of the March 2020 liquidity crisis. The spread between on-the-run and off-the-run Treasuries has been widening - a classic sign of deteriorating market function. Dealers have been less willing to warehouse risk, creating potential liquidity traps during high-stress periods.
What happens in a failed auction scenario? It starts gradually - like watching ice melt before it suddenly cracks. Primary dealers would be forced to take down excessive inventory, spreads would blow out, and the Fed would eventually need to step in with emergency measures. The odds of this playing out in the coming months aren't high, but they're certainly higher than what prediction markets are implying.
The Perfect Storm Scenario
What would cause an actual auction failure? We'd need several conditions to align:
Ongoing fiscal deterioration with rising deficits beyond market expectations
Foreign buyers (particularly China and Japan) reducing their Treasury purchases
Domestic banks facing liquidity constraints that limit their ability to absorb new issuance
Market volatility that causes primary dealers to reduce risk appetite
A specific geopolitical or economic shock hitting during a major auction
While all five factors aligning remains unlikely, we're seeing concerning developments in at least three of these areas already. The deficit continues to expand, foreign Treasury holdings have plateaued, and market volatility has been elevated.
The first sign of trouble wouldn't be an outright failed auction - that's the financial equivalent of a nuclear meltdown. The precursors would be more subtle: widening spreads between when-issued and auctioned securities, primary dealers taking larger portions of auctions, and the yield curve steepening as term premiums rise.
Investment Implications
How do you position for this potential dislocation? There are several approaches:
First, Polymarket offer a way to express views on specific outcomes - like the probability of an auction where the bid-to-cover ratio falls below a critical threshold (historically around 2.0).
Second, traditional markets provide opportunities through yield curve positioning, Treasury volatility trades, or currency options that would benefit from dollar stress.
Third, alternative assets like gold and bitcoin tend to benefit from monetary system stress. It's no coincidence gold recently touched $3,000, partly reflecting these growing concerns.
The key lesson from history is clear: Treasury market dislocations don't happen gradually and then suddenly - they happen suddenly, then more suddenly. The time to position for this potential stress is before it appears in headline news, not after.
Keep watching the signals, not the noise.
Disclaimer: This article is for informational purposes only and does not constitute investment advice. Always do your own research and consider your financial situation before making investment decisions.
Remember what goes up must come down (eventually)
Stay safe and invest wisely and this is in no mean financial advice. [Full Disclaimer]Thank you for supporting this newsletter. It will keep improving.
Harry