Tuesday, March 25, 2008

Liquidity traps and negative repo

(FT Alphaville) Panic over apparently. While the UK enjoyed the final, freezing day of its long Easter weekend, financial Armageddon receded by one step in the US. Result? A triple-digit melt-up in the London market at the start of the week.

Treasury bill rates jumped on Monday. The TED spread - the difference between three-month Treasury bills and three-month libor - narrowed but remains lamentably high. Fear and financial fever remains. The panic which last week drove T-bill yields towards zero did not presage the worst of the worst, suggests John Jansen at Across the Curve.

But the prospect of an impending liquidity trap, where the central bank’s policy tools become ineffective, put the frighteners on Brad de Long for one.

Alea reminds us that interest rates can drop below zero. Jck links to a New York Fed paper which examines why market participants are sometimes willing to pay interest on money lent. The ability to “fail” - not to deliver a security on time - without explicit penalty should establish a floor of zero to the general collateral repo rate - the rate at which a lender of funds will lend in exchange for a variety of Treasury securities as collateral. As the rate tends towards zero, it become cheaper to fail than to honour a negative rate. Fails have been rising, Jck noted last week.

In a situation though where the ancillary costs of fails increases dealers may be willing to pay interest on money lent to borrow securities needed. So it may be less expensive to pay interest to borrow notes needed to avoid fails rather than incur the related costs.

The negative rate on lending really reflects a scarcity premium being paid for certain securities. In the repo market, Alea adds, we could now say that the entire Treasuries market is on “special.” A special collateral repurchase agreement is one where a particular security is designated as the only acceptable collateral, as dealers lend money to borrow specific securities. The greater the demand for a specific security relative to the supply available, the lower the specials rate below the general rate.

So what next? Jck and Jansen’s correspondent agree. The Fed is intent on supplying extra liquidity through a multitude of channels. The market is hoping that the Fed’s first $75bn term securities lending facility this week will help clear up the shortages in the market. But as we approach the end of the quarter the market is set to remain tight.

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