Living with negative repo rates | FT Alphaville

Living with negative repo rates

The market has been getting used to negative repo rates ever since the Fed introduced fines for failed US Treasury deliveries on May 1st. However, negative rates of 3 per cent are perhaps a little more than the market may have been prepared for.

From Bloomberg on Wednesday:

June 3 (Bloomberg) — Demand for 10-year Treasury notes in the $5 trillion-a-day market to borrow and lend government debt pushed the repurchase-agreement rate for the security to the lowest since a penalty for trading failures was implemented.  The overnight repo rate on the benchmark 10-year note maturing in May 2019 dipped below negative 3 percent this week, the first issue to trade at or below minus 3 percent since the penalty began on May 1, according to NewEdge USA LLC.

“The need for 10-year notes continue to push the issue to new lows” in the repo market, wrote Scott Skyrm, head of repo trading at NewEdge in New York, in a note yesterday.

“According to the Fed, there were big borrowing requests from the Street in this issue. The issue will continue to be special as many shorts are having to extend.”  A three-percentage-point penalty is levied on failures to make good on delivery commitments. It was implemented by the Treasury Market Practices Group to help reduce uncompleted trades.

As the story explains, widely sought after on-the-run paper is now so much in demand traders caught short are happy to pay a premium to get hold of it.  Bloomberg calculates the penalty for failing would otherwise add an incremental cost of $833.33 per day on a delivery of $10 million worth of bonds.

Dow Jones reports the situation persists on Thursday with repo rates at a still hefty -2.8 per cent as “dealers scramble to borrow the note to cover massive shorts”.

Although if you still don’t get it, here’s an even better explanation of what’s causing the phenomenon from bonds blog Across the Curve:

When one shorts a bond he needs  to make delivery of the security and the security must be borrowed from someone. Typically, when one borrows a bond he (or she) is giving money to someone and earning interest on those funds. For a bond on which there is special demand the interest earned can be lower than prevailing short term rates. In effect, the owner of the bond receives a preferential financing rate because of strong demand for the bond in the “repo” market.

This is  turning out to be longer than I thought but bear with me. When the funds rate was 3 percent or so the penalty to the lender of the funds would be that he might earn as much as 300 basis points less than the overnight financing rate if demand was such that the repo rate on the heavily demanded bond fell to zero. That was an onerous penalty and could make shorting an issue an expensive proposition.

However,the penalty became less onerous when the Fed reduced rates to nearly zero. If the overnight rate is 25 basis points and the repo rate is zero then the penalty in foregone interest is quite small. This would encourage shorting of issues and created massive delivery problems as deliveries could not be completed.

The Federal Reserve and the Treasury and dealers solved the problem by implementing NEGATIVE Repo rates on May 01 2009.  So to get back to my original example of the 10 year note. If one is short that bond today and needs to borrow it,one actually lends the money to the other dealer (who supplies the 10 year note) and rather than earning interest on the proceeds you pay the owner of the bond 3 percent for the right to rent that bond. So you lose 3 percent overnight on the transaction.

So what does a -3 per cent rate actually indicate ? Well, Across the Curve agrees with Dow, it’s almost definitely the result of some massive shorts in the 10-year market, being caused by the effect of negative convexity.  As the blog explains:

The shorts would come from two sources. When the mortgage convexity folks pay in the swap market, generally the dealer who has received from the MBS client is now long the market. That trader will hedge that transaction by selling Treasuries. Given the extent of the paying in mortgages that trade has been substantial.

The second source of shorts is the yield curve trade. The 2year/10 year  spread has widened to record levels. Many traders are long 2year notes and short 10 year notes. I think that position is massive and has abetted the repo bid in the 10 year issue. 

And here’s the key takeaway:

What can we do with all of this information? We can use it to be wary of sharp rallies in the 10 year note as when the student body decides to move left or right in unison on this one it should produce a significant improvement in the 10 year note.

It’s also worth noting (in view of the convexity effect) that long-term US mortgage rates continue to rise, which effectively only adds fuel to the fire. On Thursday rates on 30-year mortgages jumped to 5.29 per cent, their highest since December. Only a week earlier they had stood at 4.91 per cent.

And as Bloomberg observes,this could ultimately stagger any prospective US house-price recovery:

Rising rates may deepen the U.S. housing slump and sideline consumers hoping to refinance or purchase their first house. The number of Americans signing contracts to buy previously owned homes climbed 6.7 percent in April, largely on cheaper financing costs, according to the National Association of Realtors.

Related links:
Maximum negative convexity – FT Alphaville
– FT Alphaville
The Fed’s asset-liability mismatch – FT Alphaville
Is the Fed losing control? – FT Alphaville
Mortgage convexity risk – Investing in bonds