Treasuries are in such high demand that investors are lending cash for next to nothing to obtain the securities as collateral through so-called repos, which dealers use to finance their holdings. The problem is many parties involved in repos aren’t delivering the bonds because there is no penalty for not doing so, causing “fails” to exceed $5 trillion, according to the Federal Reserve Bank of New York.
Now, an industry group is trying to fix the mess, which New York Fed Executive Vice President William Dudley said could cause U.S. borrowing rates to rise if not rectified. The Treasury Market Practices Group wants to impose a “penalty” on failed trades, a move that may result in borrowers who put their Treasuries up as collateral for loans effectively receiving 2 percent interest.
“This is an extraordinary thing to perceive for a market of the size and significance of the U.S. repo market,” said Lena Komileva, an economist in London at Tullett Prebon Plc, the world’s second-largest interdealer broker.
Failures to deliver or receive securities climbed to a record $5.311 trillion in the week ended Oct. 22. While the amount fell to $1.26 trillion by Nov. 12, that’s still above the average of $165 billion before credit markets seized up in August of last year, based on Fed data that goes back to 1990.
The disruption in the repo market comes as the Treasury steps up debt sales to finance a record budget deficit and the bailout of the nation’s banks. Gross issuance of Treasury coupon securities will rise to about $1.15 trillion in fiscal 2009 from $724 billion last year, according to New York-based Credit Suisse Securities USA LLC, one of the 17 primary dealers that are obligated to bid at the government’s auctions.
“The more chronic fails disrupt the Treasury market, the more it reduces its liquidity and efficiency,” Dudley said in a Nov. 12 interview. “Over time, this could have some negative consequences for the ability of the U.S. Treasury to raise money at the lowest cost possible. Reduced liquidity also affects other markets as the Treasury market is used to hedge positions in other security classes.”
Karthik Ramanathan, Treasury’s acting assistant secretary for financial markets, “strongly” urged dealers, traders and investors on Nov. 5 to find a way to reduce the number of failed trades. Otherwise, he said, regulators would step in.
In a repurchase agreement, one party provides cash to another in exchange for a security, and vice versa. Repos are typically used to finance holdings, meaning movements in the rates affect the cost of holding the securities in inventory. As of the end of June, primary dealers reported financing $4.22 trillion of fixed-income securities with repo agreements, according to the Fed.
Since the bankruptcy of Lehman Brothers Holdings Inc. in mid-September traders, investors and dealers have been willing to lend cash to obtain Treasuries at almost zero interest. The lowest overnight repo rate on Nov. 21 was 0.05 percent for the five-year note maturing in October 2013, according to London- based ICAP Plc, the world’s largest inter-dealer broker.
Repo trades go uncompleted when it’s difficult to obtain the securities or the cost to get them becomes too expensive. Fails aren’t usually considered a breach of contract and the parties involved typically keep re-scheduling delivery.
A day after Ramanathan’s warning, the Treasury said it was reviewing the trading of two- and five-year notes after a scarcity in the securities led to rising fails. The Treasury has conducted at least nine such reviews, known as “large position reports,” to monitor against market manipulation since 1997.
A week later the Treasury Market Practices Group recommended imposing a penalty rate that equals either 3 percent minus the Fed’s target rate for overnight loans between banks, or zero, whichever is greater. The central bank’s target is 1 percent. The TMPG said it plans to discuss by Jan. 5 a potential plan to implement the measures.
“A negative rate repo is somewhat counterintuitive as basically, a lender is not only lending money, but paying a borrower to take that money,” said Robert Toomey, managing director of the Securities Industry and Financial Markets Association, a New York-based trade group. “The borrower has something, in this case a particular security, that the lender really wants. It’s essentially paying a premium to get a particular security.”
Negative repo rates have happened before. The Bank of Japan’s decision to adopt a zero interest-rate during the “Lost Decade” of the 1990s because of deflation and a protracted banking crisis triggered the phenomenon for Japanese government debt. Rates less than zero surfaced in the U.S. in 2003, when the Fed’s target interest rate fell to 1 percent and traders sought to cover bets against 10-year Treasuries after their yields jumped more than a percentage point in about a month.
Demand for short-term Treasuries may increase if repo rates turn negative as investors would receive interest, as opposed to typically paying it, for money they borrow to finance their holdings.
Credit Suisse expects the two-year Treasury note’s yield to fall to 0.5 percent by the end of the first quarter from about 1 percent last week.
“For certain sectors of the Treasury curve, such as the short-end, the implementation of negative repo rates would provide a significant kick to the market,” said Ira Jersey, an interest-rate strategist at Credit Suisse in New York. “Yields have room to fall further, with the front end outperforming the long end.”
Treasury yields tumbled to record lows last week, with two- year notes dropping below 1 percent for the first time, as deepening recessions in Asia, Europe and the U.S. and signs of deflation drove investors to the safest assets.
The yield on the 1.5 percent note due October 2010 slid 9 basis points to 1.11 percent, according to BGCantor Market Data. The price, which moves inversely to the yield, rose 5/32, or $1.56 per $1,000 face amount, to 100 24/32. Five-year note yields dropped as low as 1.87 percent, the least since the Fed first started keeping records in 1954. Treasuries were little changed today as of 11:50 a.m. in Singapore.
Like in Japan in the 1990s, traders have increased bets that the Fed will cut the target federal funds rate as the economy sinks deeper into recession, further increasing the chances of negative repo rates. JPMorgan Chase & Co. economists forecast a reduction to zero percent.
Fed policy makers predict the U.S. economy will contract until the middle of next year, according to minutes of their Oct. 28-29 meeting released Nov. 19. Government figures showed that consumer prices excluding food and fuel costs fell for the first time since 1982 last month.